CORPORATIONS

I. General Introduction – Business Associations

1. General Observations General concepts of business associations apply to all entity structures Forms of business association – different intersections of law and economic organization

o Corporationso Partnership – enduring form of non-corporate business association

Good for ownership of real estate, management of apt complexes, shopping malls, etc, production of entertainment products

Primary focus of business association law – Transactional rather than adversarialo Trying to combine people, money, interests in a way that maximizes the intentions of all

the parties and makes it possible to satisfy as many desires as possibleo Value additive component of lawo Not just legal, not just economic

Forms of corporate/association lawo Primarily statutoryo Regulatory levelo Some case/common lawo Mixture of state and federal – federal developments are much more recent

2. Remarks About Corporate Fraud Incentives and Conduct – argument in corporate law that one of the ways to minimize agency

costs (slackers, lazy executives) is to provide executives with incentives to make the company perform wello Incentives can take a range of forms – stock options, market oriented compensation,

bonuses based on stated earningso In theory, incentives executives acting to maximize corporate performanceo Reality, incentives other kinds of conduct as well…

When the performance isn’t there, there’s an incentive to fake it, to exaggerate performance to support increased executive compensation

o Risks and Consequences – impairs the credibility of the market and legal systems

LAW OF AGENCY

II. Agency Law Introduction

1. General Principles Definition of agency (Restatement §1) – “the relationship which results from the

manifestation of consent by one person to another that the other shall act on his behalf and subject to his control, and consent by the other so to act.” (Gordon)

P – Principal, Employer, Mastero A legal person of some sort – actual individual, corporation or any other bus associationo Responsible for actions of agents…

A – Agent, Actor, Employee, Servant – also a legal person…o Employee – different types of employment create different risks of liability for employero Partner – can be a very risky form of agency, all partners are agents of the otherso Corporate officer

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Analyzing the agency relationship - Relationship of agency and authority is viewed as position of status, not of contract.o Is there a relationship between P and A?

Don’t need a formal hiring, doesn’t need to be a business relationship, doesn’t need to be a compensated relationship (Gordon)

o If there is a relationship, what is it?o What are the dimensions of the relationship? What is it’s scope? How broadly does it

extend? At what point does the relationship get broken? At what distance are actions outside

the scope of the relationship?o What are the implications (legal and practical) of the relationship?

Consider the underlying social implications as well… Does this type of relationship cover the type of liability incurred through the

particular action/incident in question?2. Gorton v. Doty (Idaho 1937) (p.1) – Who is an Agent?

Pre-mandatory automobile insurance case. Involved person loaning car to another on condition that only that other can drive it.

Was the driver the agent of the car’s owner? YES. Court imposed an agency constraint regardless of the agreement between the parties –

recognizes presumption that driver is agent of ownero Court wanted to get to this result – because insurance company would pay judgment,

need to hold party tied to the insurance liable Trying to spread costs through the insurance pool Different now that there are mandatory owner liability statutes to cover this

Dissent – agency needs more than this, “involves request, instruction or command,” this was just a loan

3. Gay Jenson Farms Co. v. Cargill, Inc. (Minn. 1981) (p.7) Case arose out of financial collapse of Warren Seed & Grain Co, a local grain elevator. C, the

defendant, was a worldwide grain dealer that had loaned money and exercised significant influence over W. Plaintiffs want W (now insolvent) to be C’s agent so that they can recover from C.o Creditor exercising control over its debtors after the debtor has experienced financial

difficultyo P and A are both business entities rather than individuals

Did “C, by its course of dealing with W, became liable as a principal on contracts made by W with plaintiffs”? YES. C had sufficient control and influence over W.o The lender began to become involved in the day-to-day business of the borrower, made

more than a superficial connection, adopted a position of some control Both considered it a lender-borrower relationship, but… Made conditions on the lending – information, mandatory disclosure, inability for

borrower to make certain major decisions/actions w/o permission Borrower required to get permission from lender, risks having loan called if

acting without permission real control C had acted as W’s agent in other things, and seemingly vice versa “The point at which the creditor becomes a principal is that at which he assumes de

facto control over the conduct of his debtor.” Not a buyer-supplier relationship – suppliers receive fixed prices regardless of price

paid, act in their own name and receive title to property which is then transferred again, have an independent business buying/selling similar property

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General Proposition: Parties can find themselves in the position of P and A without meaning to because of the structure of their other relationships, nature of control exercised in relationship – Paternalistic, involved relationship is probably agency.o “Control” is used as the touchstone for the existence of an agency relationship. o Court recognizes how Agency deals with a set of conditions, not a single factor – Agency

can be proven by circumstantial evidenceo And that an agency relationship may be created even though parties didn’t call it that or

intend for it to happen Problem – how to create one type of relationship which includes some element of control but

avoid establishing agency relationship?o One answer – follow absolutely formal, standard procedures, keep relationship very

minimal

III.Contractual Obligations

1. General Observations – Issues concerning the extent of contractual liability imposed upon principals because of contractual dealings between agents and 3rd parties Contractual Relationships – dealing with the connection between P and A

o Is A an agent? Or is A an independent contractor? If P has engaged A to act for P under P’s directions agent If P has entered into a contractual relationship but A is acting more for himself

independent contractor Dos A have his own separate business, his own interests, hired to achieve one

end result but without submitting to control over the processo If so, what is A’s authority?

Interactions w/ 3rd party – 3rd party is under obligation to determine whether A is authorized, is actually an agent of P for the particular transactiono Can/should demand assurance of A’s authority – may not accept authority as easily as the

law would acknowledge an agency relationshipo 3rd party shouldn’t rely on appearances if possible, shouldn’t just assume authority

Defense to liability - How do you defend against employees who use their delegated authority irresponsibly?o Employee handbook including guidelineso Require approval by the Board or a third partyo Internal audits of employee’s transactions

2. Levels of Authority – Once there is an agency relationship, there are various sorts of authority given to the agent, various rules for attributing A’s actions to P Actual Authority – P makes A an actual A, wants A to act on P’s behalf, intends that A

act in a certain wayo Expressed: Verbally or through writing granting agency.o Implied: If an action is so understood between two people, it creates a legally binding

agency relationship. There is implied authority to do those things that are inherent in the job. “Actual authority circumstantially proven which the principal actually intended the

agent to possess and includes such powers as are practically necessary to carry out the duties actually delegated” (Mill Street Church)

Apparent Authority – Power to bind without the right to bind, without legitimate authority o Definitions:

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“not actual authority but is the authority the agent is held out by the principal as possessing. It is a matter of appearances on which third parties come to rely” (Mill Street Church)

“when a principal acts in such a manner as to convey the impression to a third party that an agent has certain powers which he may or may not actually possess” (Lind)

o Ability to bind a P against P’s will, binds P for actions that were not initially intended P does grant A authority for something, how far does that authority extend when P

puts limitations on it or terminates it? Appearances may extend beyond actual authority Must be for something beyond scope of actual authority, if A’s action was

something P intended then it’s covered by actual authority Ex: P hires A to sell P’s car, for no less than 1000$. If P sells for 1100, had actual

authority to do so. If P sells for 900, P is still bound because of A’s apparent authority.

P must be careful to structure agency relationship to avoid actions taken with apparent but not actual authority – this is a status arrangement, P bears risk/costs because of status P gave to A

o Forms of Apparent Authority, ways it arises: Continued course of dealing – P’s initial actions give 3rd party impression that A is

acting as agent by continuing course of dealing. 3rd party has to confirm agency initially, but doesn’t have to for every transaction

– would undermine the practical purposes of agency If A once demonstrates his authority, and confirms it enough to establish course

of dealing, 3rd party can assume authority at some point, rely on course of dealing Risk – A’s actions might establish course of dealing w/o P’s knowledge

Secret Limitation - If P makes A’s limitations secret 3rd party can hold P responsible for things despite the limitations. See Watteau v. Fenwick.

Trade practices, power of position, surrounding circumstances, evidences of authority – when P clothes A with indicia of authority, A will appear to be an agent even w/o actual authority.

Continuation/Termination: Must give notice than an agent has been terminated. If A has been terminated but P hasn’t notified 3rd parties who recognize A as an

agent, A can still act as an agent. P will be bound until P has affirmatively notified all known 3rd parties with whom A has interacted, or published notice.

P always runs a risk if P fails to notify Estoppel (sort of): Subset of apparent authority – tied into general representation

issues P authorizes A for a transaction A makes a misrepresentation to B B

detrimentally relies on the misrepresentation A and P are estopped from denying or escaping the misrepresentation, bound by the initial promise

o Note: apparent authority is rooted in status and not in a notion of estoppel (i.e., misrepresentation of fact).

o Note: when a business sets up an interface such as a telephone hotline or a website, it may be liable under a theory of apparent authority even if it is “captured” by an unauthorized person.

Inherent Authorityo Definition – arises “solely from the designation by the principal of a kind of agent who

ordinarily possesses certain powers” (Lind) Used to impose liability on P when there is neither actual nor apparent authority

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o Some sort of authority that inheres in the position, regardless of any kernel of actual authority Cases where there is some prenumbral authority beyond actual authority, but not

under apparent authority circumstances. In other words, trust in an agent alone gives the agent some authority beyond her mandate.

o Less functional, mostly another argument to bolster agency arguments3. Mill Street Church of Christ v. Hogan (Ky.App. 1990) (p.14) – Authority

Bill Hogan hired Sam Hogan to help with job for the church. Sam was hurt and wanted to collect workers’ comp. Only able to if he was legitimately a church employee.

Did BH have the authority as an agent of the church to hire SH? Yes, had implied authority as an agent to hire SH.o No express actual authority, but implied actual authority based on nature of work,

circumstances Relying on what agent believed – whether A reasonably believes b/c of past/present

conduct from P that A had certain authority o Distinguishes implied and apparent authority. First is constructively determined actual

authority. Second is a matter of appearances.o Clear equitable underpinnings – SH believed BH could hire him, would be unfair to him

to change that now… Problem – puts every employee in position of implying powers to hire others if they feel the

job “demands” it… employer MUST fix conditions/requirements for hiring4. Lind v. Schenley Industries, Inc. (3d Cir. 1960) (p.16) – Apparent Authority

Dispute over 1% commission on gross sale ostensibly offered as a term of Lind’s employment

Was Kaufman authorized to grant the commission? Corporate officer granted extremely high compensation contract, was the company bound? YES. P&T can be held accountable for Kaufman’s action, officially on ground of inherent authority but really also on grounds of apparent authority.o All appearances and implications indicated that he had authority to do it – he seemed to

be a legit spokesman for the P&To Testimony that there was no express authority doesn’t discount apparent authority o Also supported by inherent authority – corporate officers should inherently have

authority to set compensation terms for their employees, decisions like this come with the job

Message re: corporate planning – demand all decisions in writing to cut of potential for decisions made through implied or inherent authority

5. Three-Seventy Leasing Corporation v. Ampex Corporation (5 th Cir. 1976) – Apparent Authority Contract for purchase of computer hardware required final signature from Ampex, but it was

never signed. Delivery date was confirmed anyway. Was the contract still binding? YES, conduct contradicted the supposed need for written

approval.o Document itself was only an offer, but subsequent conduct was acceptance, and the

conduct was on the part of someone with apparent authority to bind the companyo Message – if you sit on a contract, you may still be responsible for it

Test for apparent authority: whether a reasonably prudent person would have supposed that the agent has the authority he purports to exercise.o “An agent has apparent authority sufficient to bind the principal when the principal acts

in such a manner as would lead a reasonably prudent person to suppose that the agent had the authority he purports to exercise. … absent knowledge on the part of third parties to

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the contrary, an agent has the apparent authority to do those things which are usual and proper to the conduct of the business which he is employed to conduct.” But there’s an obligation for the 3rd party - Listening to the agent’s representations of

authority may not be enough. 3rd party should check with P if possible6. Watteau v. Fenwick (Q.B. 1892) – Inherent Agency Power, Undisclosed principal

Pub manager held himself out to be independent, but was actually bound by a principal and was not authorized to enter into contracts.o Fully undisclosed rather than partially undisclosed principal – different risks for 3rd party

What are the consequences of an agent’s acting for an undisclosed principal. Were they binding? YES. The contracts were binding. o “once it is established that the defendant was the real principal, the ordinary doctrine as to

principal and agent applies – that the principal is liable for all the acts of the agent which are within the authority usually confided to an agent of that character, not withstanding limitations, as between the principal and the agent, put upon that authority.”

o By allowing undisclosed relationship, P granted at least apparent authority to A to do whatever was in the scope of A’s position, A had authority to do everything inherent in the position, appearances didn’t divulge secret limitation Equity concerns – only fair to 3rd party who assumed that A was in charge

Implications for 3rd party – what if 3rd party wants to get out of deal with P reveals himself? Only if presence of P changes a material term of the deal, NOT just the price

Restatement §194, 195 – undisclosed principals are liable for acts of agent if acts are usual for the business, even if contrary to directions of principal

7. Kidd v. Thomas A. Edison, Inc. (SDNY 1917) (p.28) – Inherent Agency, as defined by Learned Hand. Fuller contracted with opera singer Kidd performed tone recitals for phonograph company. Did Fuller have authority to bind company in contract with Kidd? Or was he only authorized

to engage her for such recitals as he could later persuade dealers to book? Authority to bind the company, contracts immediately valid, based in his inherent authority.o No implied actual authority because the position was unique at the time – can’t imply

from circumstanceso But inherent authority – actions taken inherently have the power to bind company

Once selected as an agent, customary implication is of authority without such a specific, unusual limitation

o As long as A acts within the usual sphere of delegation, even if disregarding P’s specific directions, and actions are that typical P may be bound

o Practical concerns – “very purpose of delegated authority is to avoid constant recourse by third persons to the principal” “If a man select another to act for him with some discretion he has by that fact

vouched for some extent some reliability. While it may not be fair to impose upon him the result of a total departure from general subject of his confidence, detailed execution of his mandate stands on different footing”

“the very purpose of the relation demands the possibility of the principal’s being bound through the agent’s minor deviations.”

o Note that there is a very subtle distinction in reasoning: there can’t be implied authority in a novel circumstance, because the implication involves an appeal to established custom. However, there can be apparent authority in a novel situation because it can be established by analogy to a familiar situation. More like binding advertisement than typical performance contracts

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Note: Hand’s estoppel argument is wrong, this is NOT the basis of agency power we now use. He says that “if estoppel be, therefore, the basis of all apparent authority, it existed here.” But that’s not true…o Now focus NOT on status or reliance but on consent

Inherent authority rule – P will be bound for all of A’s actions that fall w/i inherent scope of jobo P may not be able to strip A of powers that are so typical of A’s position

8. Northland Insurance – Not in class, discussed 1/19 – Inherent authority Insurance company sells/operates by phone. Customer calls to change policy, impostor

answers and “changes” her policy. Company is still bound. Why? Inherent authority in the voice. Apparent authority in the situation – P created apparent

authority by clothing the voice with indicia of authority, caller expects person who picks up phone to be someone who works there and has authority o Underlying policy – can’t impose these risks on the customer, up to Northland to monitor

their phoneso Inherent authority – for a business conducted by phone, legit person in this situation must

have authority to do what was done Use inherent arguments to back up apparent arguments Problems for potential P’s – there are some sorts of undesired actions that are so

integral to/inherent in A’s position that P will not be able to escape liability 9. Nogales Service Center v. Atlantic Richfield Company (Ariz. 1980) – Inherent Authority

Classic inherent authority case – though actually a dispute about giving inherent agency jury instructions. o A principal can be liable for acts within an agent’s domain even if the principal has

forbidden the agent from acting.o ARCO claims agreement was outside manager’s authority, but if so inherent, there might

not be any defense Inherent authority most often occurs when there is a “general agent” who is restricted from

entering into a particular contract, but whose general domain of authority includes actions like the one entered into. o Indicates power of an agent derived not from authority, apparent authority or estoppel,

but solely form the agency relation and exists for the protection of persons harmed by dealing with a servant or other agent (restatement §8A)

o 3 Typical Situations: When A does something similar to what he is authorized to do, but in violation of

orders When A acts purely for his own purposes in entering into a transaction which would

be authorized if he were actuated by a proper motive When A is authorized to dispose of goods and departs from the authorized method of

disposal Bottom line – if A’s conduct is that typical of the position, courts won’t let P escape liability

o “it is fairer that the risk of loss caused by disobedience of agents should fall upon the principal rather than upon third persons” – equity concerns

IV. Ratification and Estoppel

1. General Observations: Ratification: “the affirmance by a person of a prior act which did not bind him but which was

done or professedly done on his account” (restatement §82), requires “acceptance of the

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results of the act with an intent to ratify, and with full knowledge of all the material circumstances” (Botticello)o A acts in an attempt to bind P and must be acting on P’s behalf, but A didn’t have

authority. If P learns of A’s act (all of its material aspects) and does not renounce it (ratifies it), P will then be bound. P can ratify actions P didn’t initially authorize

o What types of action constitute an affirmation by the principal? Forms of ratification - both silence and affirmative statement can be sufficient. Botticello court was strict, but accepting/ratification through conduct normally

allowedo What effect should we give the affirmation?

Legal fiction – ratification used to establish past consideration, consideration at time of transaction, dates back to the agreement

o Consequences – ratification may lay basis for course of dealing, establishes some actual and some apparent authority P should specify extent of ratification, and make sure to really investigate what’s

being ratified Estoppel – 3rd party detrimental reliance on action taken by supposed agent

2. Botticello v. Stefanovicz (Conn. 1979) – Ratification of a contract Dispute over agreement for sale of real property. One party with undivided half interest

agreed to sell the property, the other didn’t. When the buyer exercised his option to buy the property, the sellers refused to honor the option agreement.

Is the contract binding? NO. Mary did not really ratify the contract.o Would have been if Walter was Mary’s agent in the transaction, but marital status, W’s

tendency to handle the business matters, M’s prior independent actions proved there was no agency relationship.

o Would have been if M had subsequently ratified its terms by conduct. Rules for Ratification – required elements

o Manifestation by P of willingness to accept contracto Knowledge of material terms of contract – blind ratification is voidable, P needs evidence

of terms and must provide evidence of acceptanceo Overall - acceptance of the results of the act with an intent to ratify, and with full

knowledge of all the material circumstances.o Receipt of benefits can not constitute ratification without the other required elements

3. Hoddeson v. Koos Bros. (N.J.Super 1957) - Estoppel Someone pretended to be a salesman at a store and collected payment from a customer. Is the store liable to the customer? YES, because estoppel precludes the denial of liability

o Attempting to find apparent authority, but even apparent authority must have some initial basis in actions of P, rather than fully from A

o BUT proprietor has a duty to take reasonable steps to prevent someone who is not his agent from acting as such, based on concerns for consumer protection

o Detrimental reliance on an appearance made in the store, put risk on those best able to handle it

Rule: where proprietor by his dereliction of duty enables a non-agent to conspicuously act as an agent and transact with a patron, and the appearances lead the patron to believe the person was an agent, “the law will not permit the proprietor defensively to avail himself of the impostor’s lack of authority and thus escape consequential loss thereby sustained by the customer.”

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V. Agent’s Liability on the Contract

1. General Observations: Will A ever be personally liable for contract? A enters contract with T, purportedly on P’s behalf – contract typically between T and P. But if T is suing, will probably sue both on alternate grounds.

2. Atlantic Salmon A/S v. Curran (Mass.App.Ct. 1992) – Agent’s Liability Defendant A represented himself as the agent of a corporation P that did not exist. A is now

trying to pass the debt/liability to the company. If P doesn’t perform contract, is A liable? What is the personal liability of an A who was

acting on behalf of a partially disclosed or unidentified P? o Generally, agents are not liable for actions taken on behalf of P – contract seen as

warranty of authority, of A’s authority to act for P If there isn’t a P, A becomes liable, but not on the contract (because contract was

between 3rd party and P) – equitable breach of warranty action Might also be able to impute personal actions into it – A knew A was really acting for

himself… A who contracts with 3rd party for a partially disclosed P is a party to the contract

And fraud issues as a backup – problems with A’s alleged good faitho And if A is liable, can sue P for contribution/indemnification

For A to avoid personal liability, A should disclose not only that he is acting as an agent but also the identity of his principal.o “duty of the agent, if he would avoid personal liability on a contract entered into by him

on behalf of his principal, to disclose not only that he is acting in a representative capacity, but also the identity of his principal.”

o 3rd party should check, but it is the duty of the agent to disclose the right info if A wants to avoid liability – not a hardship for the agent, always easy to disclose

Bottom line – when P doesn’t exist, or authority doesn’t exist A can be held personally liable, either on warranty grounds or individual action liability grounds

VI. Liability of Principals to 3 rd Parties in Tort: Scope of Employment

1. General Liability Issues: Concerned with physical actions of agents and a different underlying conception of authority

o Scope of employment provides authority for certain direct tasks surrounded by area which includes conduct and events that may/may not have been contemplated, and were not explicitly authorized

o Major difference from contract liability – intent and voluntary involvement of 3rd party With contract, 3rd party voluntarily enters into transaction with A can make

demands of 3rd party to limit liability, i.e. exercise care, diligence, obligation to check on authority

With tort, 3rd party claiming damages probably never entered into voluntary relationship with A, or at least not one covering the injury in question Can’t push the duty to check on 3rd party here

o Plaintiff will try to sue parent company/principal Deeper pockets, better insurance More accessible assets, more general remedy – take out the party at the top More attractive defendant – corporate giant rather than local operation Public perception and identification – consumers rely on the label, assume that every

branch is a legit McDonalds… Analysis

o 1st question – WHETHER there is employment to begin with

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Master-Servant/Employment relationship exists where servant has agreed To work on behalf of master and To be subject to the master’s control or right to control the “physical conduct” of

the servant (manner in which job is performed as opposed to result alone)o 2nd question – what the scope of employment is, based on core criteria of control

Actions within scope of employment are those employer has some control of2. Franchiser to Franchisee

Issue: Agency relationship between franchiser/franchisee? Analysis – typically depends on franchiser’s control of franchisee operations

o However, even w/o control, franchiser may still be liable under a theory of estoppel or apparent authority.

Rule – the control test is the determinative element, but the test is applied in various ways and “control” is never clearly definedo And proving control may not always be determinative of the particular liability at issue –

need control over the particular actions that led to the injury How does control translate into liability? Even if there’s control in a corporate sense there

may not be liability o Separate corporations may not be enough, but if there is no detailed control over day to

day operations, particularly the operations that gave rise to the liability, the parent company may escape liability

o The top company needs detailed control over the operations that gave rise to the damage to the 3rd party to be held liable for those operations

o Financial control in general wont extend liability for day to day issues… The parent company can still delegate responsibility and authority for all daily operations no liability, not detailed control

Usually, the franchise agreement will require that the franchisee will indemnify the franchiser for any tort claim. The franchisee will take out insure to cover this indemnity.o Parent companies try to write franchise agreements to avoid liabilityo Leave as many daily details to franchisee, change format of partnership, require insurance

and indemnification o Private law ordering options as a way to get around the ambiguity of common law

liability Still not a perfect option – parent still exposed to litigation Bottom line – parent company will prob NOT be able to escape liability, at least

faces litigation3. Employer to Employee

Issue: whether a particular action should be considered within the scope of employment triggering liability for employero Look for control over actions, intent of employer

Scope of Employment analysis:o Having already established employment status, questioning whether the actions taken by

the employee were within the scope of employment so that employer should be held liable

o To what extent can a variation in normal conduct still be attributed to the employero How far do we hold P/employer liable beyond those actions which P in fact authorized?

Where does A/employee cross the line and start acting for himself? Was the liability incurred because of an employment action or something more

personal/independent on the part of the employee?o Answer – Scope of employment tends to be expanded out as far as that area which

might reasonably be contemplated as within the bounds of employee’s employment

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Reasonableness standard… Servants v. Independent Contractor: 2 types of IC

o Agent-type IC: has agreed to act on behalf of a principal, but is not subject to principal’s control over how the result is accomplished

o Non-agent-type IC: operates independently and simply enters into an arm’s length transaction with others.

4. Humble Oil & Refining Co. v. Martin (Tex. 1949) (p.48) – Tort liability of parent company Car brought into filling station, rolled away and hit someone before employees even started

working on it Is the parent company’s liable for actions of employees at a service station it owned? YES.

o Facts that no one considered Humble as an employer or master, that employees were paid and directed by head of service station and that provision of franchise agreement expressly repudiated Humble’s authority over employees are not conclusive – need to look at actual circumstances not formalities or parties’ beliefs

o Other evidence about Humble’s right/power to control the details of the station work of the supervisor and therefore his employees was sufficient to prove master-servant relationship Contract with manager put him under Humble’s control, terminable at Humble’s will

– “S was H’s servant, and so accordingly were S’s assistants who were contemplated by the contract”

Humble was responsible for some operating expenses Rule – the control test is the determinative element, but the test is applied in various ways and

“control” is never clearly defined. And here, there was sufficient day to day control liability imposed on parent.

5. Hoover v. Sun Oil Company (Del. 1965) - Tort liability of parent company Very similar – liability of parent for negligence at franchise? No, no liability. “Test to be applied is that of whether the oil company has retained the right to control the

details of the day-to-day operation of the service station; control or influence of over results alone being viewed as insufficient…”o Non-binding advice by the agent of a franchiser does not in itself constitute a master-

servant relationship.o Control over details of day-to-day operations is the key test, and Sun had no control over

the daily things… Recognize the unique circumstances of the oil distribution/gas industry

o There was evidence on either side, but the stronger implications were that the station manager was an independent contractor

Underlying issue – circumstances and context determine these cases…6. Murphy v. Holiday Inns, Inc. (Va. 1975) – Tort liability of parent company

P slipped and fell in puddle caused by Holiday Inn franchisee’s leaking air-conditioner. Is Holiday Inn liable as principal, master, parent? NO. The franchise agreement did not give

HI sufficient control. Contract’s regulatory provisions did not give HI control of daily operations.o HI tried to argue that it only leased the use of the name, and had no other relation with the

hotel Analysis: Based on terms of the franchise contract – if the license agreement is sufficient to

establish an agency relationship, disclaimer (trying to avoid connection) will not defeat it. Test based on nature, extent of control agreed upon. o Contract was for a hotel “system” – a variety of HI elements

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o Franchising is a common business form. Status of franchisee as independent contractor should be recognized by courts, but court doesn’t see agreement as insulating contract parties from agency relationship “if a franchise contract so regulates the activities of the franchisee as to vest the

franchiser with control within the definition of agency, the agency relationship arises even though the parties expressly deny it.”

o Regulatory provisions of a typical licensing contract do not constitute a master-servant relationship.

Unusual holding: As it is so difficult to predict where the liability lies, you should decide liability at the outset and write it into the contract, and thus avoid these problems. avoid problems of agency arising contrary to parties’ intent

7. Billops v. Magness Construction Co. (Del.Sup. 1978) – Tort liability and apparent agency Fraud regarding ballroom rental Were the franchisers liable for the torts of the franchisee? YES. Because of actual and

apparent authority.o Court struggles with development of franchise practices – people are relying on the

franchise name in getting into the contracts, but franchiser might not have sufficient control to establish liability Imposing liability is easy when franchiser has actual control of franchisee – there was

actual control here Can also impose liability based on apparent agency

Test – what reasonable basis is there to decide for or against plaintiffs?o Relying on the control notiono Test is whether the franchiser is merely ‘setting standards’ or actually exerting control

over daily operations. Need to look at the details, but control can go both ways Is there enough control by parent to make franchisee servant of franchisor

Without control, is there another grounds for liability? Apparent agencyo Appearance of control or connection - Can be ‘apparent agency’ in tort if the litigant can

show reliance on the indicia of authority originated by the principal and such reliance is reasonable. If franchisee is holding itself out as being controlled and 3rd parties rely on the

appearance There was no way for 3rd parties to know they were dealing with anyone other than

Hilton here…8. Ira S. Bushey & Sons, Inc. v. United States (2d Cir. 1968 – Scope of Employment

“A seaman returning from shore leave late at night, in the condition for which seaman are famed” – introduction immediately indicates that conduct contemplated as w/i character/scope of employment

Friendly: Respondeat superior rests on the belief that a “business enterprise cannot justly disclaim responsibility for accidents which may fairly be said to be characteristic of its activities.”o Don’t necessarily need to find an employment purpose for the actions – ignoring

Restatement §228 which considers conduct not within scope of empl if it is “too little actuated by a purpose to serve the master”

o It’s not just about imposing costs on those most able to bear them Test for scope of employment – Employer should be held to expect risks that “arise out of

and in the course of” agent’s employment, and should therefore be liable for them. Just need to show that conduct arose out of/in the course of employment.o Evaluate proximity, reasonable expectations, nature of human conduct.

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His actions were not so unforeseeable that it would be unfair to impose liability on employer

o If you hire someone to perform physical conduct for you, you’ll have a tough time limiting your liability – their actions need to be extremely personal to get out of it

Consequences - Close to a presumption of liability – within certain (wide) boundaries, even violent, willful actions of A will bind P.o Lesson – Employers NEED to get insurance of all kinds, even covering intentional

misconduct9. Manning v. Grimsley (1 st Cir. 1981) – Scope of employment

Pitcher whipped ball at hecklers and injured one. Was the baseball team liable for pitcher’s actions? YES, because hecklers were interfering

with the pitcher’s ability to do his job. o Pitcher was liable personally as well – intentional battery

Mass Law test for employer’s liability for employee’s assault: whether plaintiff’s activity interfered with the employee’s ability to perform his duties successfully.o P must show that employee’s assault was in response to P’s conduct which was presently

interfering with employee’s ability to perform his job o If assault was in response to P’s interference with job performance employer also

liableo Not in the case but - Also, a servant’s use of force is within the scope of employment if

not unexpectable by the master. Restatement § 228(2).) Expectable force imputable liability

Results - As long as within scope of employment, even consciously/intentionally criminal/tortious conduct can be attributed to the employer.o In situations like this now, company would not even try to avoid liability

10. Arguello v. Conoco, Inc. (5 th Cir. 2000) (p.69) – Statutory Claims, Interaction of employer’s tort liability with statutory, regulatory structure Customers suing Conoco for racist treatment in C-owned and C-branded stores under Civil

Rights Acts and §1981. Is C liable? Trying to take out the top parent, ultimate corporate source of any racism b/c its

easier than taking on individual service stations…o Not for actions at branded stores – franchise agreement does not establish agency,

without evidence of sufficient control Contract expressly rejected agency relationship Contract set certain guidelines but did not give C control of daily operations

o Yes for owned stores, as long as employee’s actions were within scope of employment. Smith clearly an employee, so if actions w/i scope of employment C is liable Factors used in determining scope of employment include:

Time, place, and purpose of the act Similarity to acts which the servant is authorized to perform Whether the act is commonly performed by servants The extent of departure from normal methods Whether the master would reasonably expect such act would be performed

Just because her conduct was intentionally tortious doesn’t bring it outside scope of employment

Just because her conduct was unacceptable or unexpected also doesn’t Dismissed potential ratification arguments – C didn’t ratify employee’s racist

behavior (which would have cemented liability) because employee was reprimanded.

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Employment status important here less because of common law liability than because an agency relationship will trigger other forms of liability conclude that there is no non-delegable duty not to discriminateo § 1981 is meant to prohibit intentional discrimination, not to make employers the

guarantors of rights against all 3rd parties. Thus, P must establish a close connection between the ER and the 3rd party who engages in the intentional discrimination in order to make ER liable.

11. Majestic Realty Associates, Inc. v. Toti Contracting Co. (N.J. 1959) (p.76) – Liability for torts of independent contractors City’s contractor goofed when demolishing building and a wall fell on Majestic’s roof.

Negligently damaged P’s building next door Is the city liable? Maybe, even though Toti was clearly an independent contractor. Depends

on determination about the risks to the public or adjoining property of razing buildings by the jury.

Rule: Liability is generally not imposed for actions of independent contractors, if there is no agency relationship.o P’s not generally liable for tortious acts of independent contractors.o “ordinarily where a person engages a contractor, who conducts an independent business

by means of his own employees, to do work not itself a nuisance… he is not liable for the negligent acts of the contractor in the performance of the contract”

Exceptions:o Liability imposed on landowner for actions of independent contractor that are inherently

dangerous or a per se nuisance. Landowner is liable for inherently dangerous situations And liability is absolute if the work is ultra-hazardous

o When landowner retains control of the manner and means of doing the work which is the subject of the contract

o Where the landowner engages an incompetent contractor Planning concerns for landowner – protect himself by preventing his own negligence

o Take out insurance against liability to 3rd parties for whatever cause – all-hazard insurance

o Demand contracts and licenses, assurances that contractor is competent and is insured

VII. Initial Comment on Fiduciary Obligations

1. General Observations What is the fiduciary obligation, or duty of loyalty, owed by agents to their principals?

2. Reading v. Regem (K.B. 1948) – Duties During Agency British soldier in Cairo made money on the sly by wearing his uniform and accompanying

civilian’s lorry through police checkpoints. An “opportunity” presented to him because of his military status.

If a servant takes advantage of his service and violates his duty of honesty and good faith to make a profit for himself, he is accountable to the master? Is the Crown entitled to the money because it was soldier’s employer? No fiduciary relationship, but YES, employer entitled to money.o Neither fiduciary duties nor scope of employment are necessary for recovery hereo More of an unjust enrichment thing - “If the servant has unjustly enriched himself by

virtue of his service without his master’s sanction, the law says that he ought not to be allowed to keep the money, but it shall be taken from him and given to his master,

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because he got it solely by reason of the position which he occupied as a servant of his master.”

o Doesn’t matter that master didn’t lose profit, suffer damage, or could have made the same profits on his own.

Evidence that servant takes advantage of employment. If cause of the profit is due to:o Company assets of which he has controlo Company facilities he enjoyso Position he occupies

3. General Automotive Manufacturing Co. v. Singer (Wis.2d 1963) – Duties during agency Machinist secretly farmed out work Automotive couldn’t handle and kept the profits for

himself. Did he breach his employment contract and violate a duty of loyalty owed to employer and

his fiduciary duties as general manager by engaging business activities for his own account? Yes, his actions were “inconsistent with the obligations of a faithful agent or employee”o “under his fiduciary duty to Automotive singer was bound to the exercise of the utmost

good faith and loyalty so that he did not act adversely to the interests of Automotive by serving or acquiring any private interest of his own … He was also bound to act for the furtherance and advancement of the interest of Automotive.”

o By failing to disclose the opportunities he then took personally, he violated the fiduciary duty to act solely for the company’s benefit

o Failure to disclose all material facts of a side business related to one’s employment can create accountability to one’s employer.

4. Town & Country House & Home Service, Inc. v. Newbery (N.Y. 1958) - Duties During and After Termination of Agency: “Grabbing and Leaving” Cleaning crew leaves company to set up rival and steals its customers. P looking for

injunction against unfair competition. Could they be prevented from competition? Was there a duty not to grab certain information

for subsequent competition? YES.o Defendants could not take client lists that weren’t publicy accessible, info to solicit

customers who are not openly engaged in business in advertised locations or whose availability as patrons cannot readily be ascertained but “whose trade and patronage have been secured by years of business effort and advertising, and the expenditure of time and money, constituting the good will of a business which enterprise and foresight have built up.”

o Can’t grab this sort of information and leave

LAW OF PARTNERSHIPS

VIII. Choice of Organizational Form

1. General Observations The structure of business associations is a matter of state rather than federal law.

o Many states use the ALI model codes. However, these uniform codes are affected by the different, potentially outcome-determinative interpretations of different state courts. RUPA (1997) RULPA (1976 with 1985 amendments)

Different forms of profit-making business entities:o Proprietorship - business owned individually by one person, not incorporated, can’t be a

partnership if there’s only one person involved

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Separate legal entity for tax purposes - schedule C rather than individual schedules, business-oriented loan interest is deductible, business-oriented expenses are deductible, etc

o Partnership RUPA definition §101(6) – association of 2 or more people to carry on, as co-

owners, a business for profit Inherently a profit-oriented activity. Doesn’t have to successfully make a profit

but needs to be profit oriented An entity distinct from its partners – RUPA §201

Though only a quasi-entity for tax purposes – Files a tax return, but doesn’t pay taxes… why? To send information to the IRS about the individual partners, who do pay taxes

And a clear entity in terms of liability – partnership can be liable, as can the partners Check and make sure this is true…

2 major forms: General partnership (GP) - All of the partners are general partners and all are

potentially personally liable for the debts of the business Limited partnership (LP) - Made up of general and limited partners – key

distinction, limited partners are not, as a general matter, personally liable for the debts of the business but liable only to the extent of their participation/contribution

Certain specialized forms:o Limited liability partnership (subset option) - designed to insulate partners

from personal liability for the malpractice of other partnerso Limited partnership with a corporate general partner – not really a different

organizational form, but has important practical differences in terms of partners’ liability

Partnership law - Partnerships are controlled by their partnership agreements, most defaults of the partnership act can be changed in the agreement and the act just provides defaults/gap fillers Benefits – parties can write agreements that are perfectly tailored to their needs,

provides a very flexible form of business association Risks – need to be perfectly clear in the agreement, courts won’t generally go

behind the agreement and will read it literally, some RUPA gap fillers are harsh options…

o Corporation - most entity-like, has its own capital, its own name, some rights as a citizen (free speech, etc), its own property, its own tax liability Corporations have a statutory basis, generally subject to state corporate law of state

of incorporation Different forms

PC – public corporation LLC – limited liability corporation There are real differences between the 2 in other countries, but the same structure

for both in the US LLC means one thing in the civil law world, and something totally different in

the US Differences between the business associations, factors to consider in choosing a business

form – for advising clients, choice of form really depends upon nature of business and nature of invetors…o Flexibility – legal and operational

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o Liability – various risks/limitations for the participants If you have an entity and you make an investment, and participate in control, will you

by virtue of your investment or your control become liable for the debts of the entity US shareholders not liable for corporate debts, while general partners are potentially

liable for debts of the partnership Private ordering may cut back on liabilities

Partnership setting – it’s possible to contract and structure the way into limited liability

Trying to avoid liability for torts, not paying taxes, not paying employees, defaulting on the mortgage, etc.

Solutions – insurance, non-recourse loans, contracts to limit liability Work it all into the partnership agreement - Most of the problems of structural

legal matters can more easily be addressed at the beginning – complicated, but better to deal with major issues up front in the partnership agreemento Increases the importance of careful drafting at the beginning

o Market and capital raising characteristicso Taxation - Major difference in the tax structures…

Partnerships and corporations have fundamentally different tax structures: Partnership income is taxed only once – as the annual personal income of

partners, partnership itself pays nothing Corporate income is taxed twice – once at the level of the corporate entity and

once at the level of dividend outlays to investors. In practice, corporations don’t usually pay out most of their income in dividends, but

instead reinvest it mitigates effect of double tax Unless liquidating, corp needs to hold on to profits in order to maintain the

business and keep it running Holding on to profits that are only taxed once

Corporations also have ways of reducing their corporate tax burden. The payment of interest on debt is tax deductible and debt (such as bonds) can have many of the components of equity and still have the advantages of debt. Not all the dividends will really be taxed at ordinary income, some wont be taxed

at all can still distribute dividends without facing double taxo Dividends paid to corporate shareholders, non-profit foundations, private

pension plans aren’t taxedo Dividends paid to aren’t taxed

In the end, the effective double tax on corporate earnings is more of a myth than a reality

Closely held corporations can distribute their profits in salary, pensions, etc. Service companies that sink costs and then extract profits – e.g., real estate

companies, movie productions, mineral extraction – tend to be partnerships for tax reasons. Not concerned with a long term business/investment, more concerned with

immediate profits, want to pass them through with only one taxo Overall, trying to structure the entity to expose participants to the least liability and

lowest taxes…

IX. Partnership Formation and Existence

1. General Observations

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The General Partnership is the only form of business association that people can enter into without filing or without a written document. Thus, it is the default for business associations.

Entity theory: Partnerships are tax-filing but not tax-paying entities. According to the RUPA, partnerships can sue and be sued as entities.

In effect, partners are principals and agents of each other. Partnerships must be for-profit.

2. Revised Uniform Partnership Act (RUPA) §101. Section on definitions. §103. Gives cases where presumptive (default) rules cannot be waived.

o Creates an explicitly contractarian structureo RUPA will provide a partnership agreement, structure, unless the parties agree otherwiseo Most RUPA rules can be changed, with some exceptions

Can’t vary rights and duties under §105, recording of instruments Can’t unreasonably restrict the right of access to books and records Can’t eliminate the duty of loyalty under §404, but it may identify specific categories

of action that do not violate the duty Can’t unreasonably reduce the duty of care under §404(c)

§201. Defines Partnershipo Declares that a partnership is an entity distinct from its partners.

§202. Formation of a partnership.o §202(a) – association of 2 or more persons to carry own as co-owners a business for

profit Occurs as a matter of status, not necessarily as a matter of explicit agreement Need intent to be co-owners Need a real business for profit – rather than a joint adventure…

o §202(c)(2-3) – Certain things that in and of themselves won’t create a partnership Shared property by itself does not create a partnership Sharing of gross returns does not necessarily constitute a partnership Receipt of a profit share creates the presumption that the recipient is a partner, unless

it’s compensation, payment for debts, etc check the statute Eliminates the presumption that profit sharers are partners, but doesn’t say that

they definitely aren’t partners – need to look to the other evidence People will rather get a share of gross returns than profit share (after-expenses)

§301. Agency of partnerso Each partner is an agent of the partnership for purposes of the business. An act of a

partner is not binding if it is not work-related, unless authorized by the other partners.o Partnership imputes automatic agency and imposes liability

§401. Partnership Agreemento Default rules when there’s a partnership but no agreement, though most of the provisions

can be altered by the partieso 401(a) – partnership accountso 401(b) – each partner is entitled to an equal share of the partnership profits and is

chargeable with partnership losses equal to the share of profits taken Without specification, partners share profits equally and losses follow profits Presumption of a democratic, equal partnership

Such democracy is NOT the presumption in corporations o 401(f) – each partner has equal rights in the management and control of the partnershipo 401(g) – partners may only possess partnership property for partnership purposeso 401(h) – partner is NOT entitled for remuneration for services performed for the

partnership, except for reasonable compensation tied to winding up the partnership

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401(i) – person may become a partner only with the vote of all partners 401(j) – voting requirements

Ordinary business decisions can be made by partnership majority Unusual business decisions, amendments to the partnership agreements must be

unanimous §404. Fiduciary Obligations

o 404(b) – duty of loyalty to partners and partnerships limited to following: Account to partnership and hold as trustee any property, profit, or benefit derived by

partner in conduct or winding up of the partnership business, or appropriation of any partnership opportunity – affirmative first obligation Same obligation at play in corporations, general employment situations, trustees

to the trust, attorneys to clients…o 404 what section - Negative obligations - duty to NOT act for an adverse purpose, duty

to refrain from competing with the partnership General obligations to not act contrary to the partnership

o 404 what section – Duty of Care 2nd broad category of obligations relating to business associations Limited to gross misconduct and negligence – but still highly debated

3. Fenwick v. Unemployment Compensation Commission (N.J. 1945) – Partnership Status, Partners compared with Employees Agreement between owner and employee said ‘partners’ because owner wanted to get out of

paying unemployment insurance.o If she was actually an employee rather than a partner, employer would have to make

payments to unemployment compensation fundo Title may have been offered as psychological perk, or for tax purposes

Was she a partner or an employee? NOT a partner, an employee.o There are several elements in determining the existence or non-existence of a partnership:

Intention of the parties (Partnership Agreement as evidence) Right to share in profits and obligation to share in losses

Profit sharing is a rebuttable presumption of partnership, can’t draw an inference of partnership if the profit share was received as compensation

Ownership of partnership property and control of business Liability for partnership debts – all should be liable if they are truly partners Community in power of administration, division of management control Language of the agreement [?] – labels and other language Conduct of the parties toward third person The rights of the parties on dissolution

o Agreement is evidence of a partnership but is not conclusive, except in cases of estoppel, where people represent themselves to others as partners. Some problems with this holding because estoppel, reliance can also be used to push

questionable associations over the partnership lineo Here there was no real co-ownership – receptionist got nothing from the agreement but a

new pay scale, labels are not dispositive Tied now to RUPA §202(c)(3): Party who receives a share of the profits is presumed

to be a partner unless the profit share is received in payment for services Rule – Still need to find the actual elements of a partnership – joint association, co-owners,

business for profit4. Martin v. Peyton (N.Y. 1927) – Partners compared with Lenders

Peyton et al. lend money to K, N, & K, under a number of conditions to protect the investment. KNK goes under and creditors try to collect from Peyton et al.

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o They were given some supervisory role, had an option to become partners, certain information rights – but all special conditions really designed to induce the loan

o Option to become an owner in particular very important – used frequently in traditional venture capital lending operations For the lender – offers the chance to participate in an uncertain future For the borrower – the potentially profitable future may make it cheaper, or initially

possible, to borrow the money But this doesn’t make you a current partner – just holding the right to become a

partnero Difference between lenders and partners important because if partners then liable for all

the debts of the partnership, not just risking their investment Did the provisions of the loan agreement actually create a partnership so that thereafter they

carried on as co-owners of a business for profit? Was this a partnership? NO. Still just a loan agreement. Defendants were creditors.o The chance to become a partner in the future does not make you a partner nowo A lender contracting for an ‘option’ for membership may be suspicious but is not

dispositive.o Trustees [lenders] may inspect the firm books and veto any business they think is highly

speculative or injurious without incurring partnership liability – protecting their investments doesn’t mean they can do everything partners can do

Planning Consequences:o Even though the lenders weren’t liable, being a partnership rather than a corporation put

them at more risk.o It makes to structure a loan with covenants that help to protect his investment. But in

order to avoid a litigable case about “partnership” status and to protect against liability, make loans only to corporations, not to partnerships. Force the borrowers to incorporate Make plans to mitigate the risks of accidentally being deemed a partner

o Also, don’t allow other people to gamble with your money for their own profit. 5. Southex Exhibitions, Inc. v. Rhode Island Builders Association, Inc. (1 st Cir. 2002)

RIBA and Southex put on shows together at the Providence Civic Center – their agreement called them “partners.”

Are they actually partners? Could the joint venture be considered an ongoing partnership? NO. There was no partnership.o Did profit sharing agreement amount to proof of a partnership? NO.o Joint tenancy of common property does not itself prove partnershipo A share of profits in a business is prima facie evidence of a partnership unless these

profits were received in payment: As a debt by installments or otherwise; As wages of an employee or rent to a landlord As an annuity to a widow or representative of a deceased partner As interest on a loan, though the amount of payment vary with the profits of the

business As the consideration for the sale of a good will of a business or other property by

installments or otherwise [?]o There was also no fixed partnership term, no sharing of the losses, their mutual

association was never given a name nor was their agreement labeled “partnership agreement,” lack of mutual control over business operations, failure to file partnership tax returns, failure to prescribe loss-sharing, didn’t interact w/ 3rd parties as partners

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o Siegel : The giveaway that there was no partnership was that SE agreed to advance all monies and agreed to indemnify RIBA for all show-related liability as well. Only one risk-taker is usually not a partnership.

Rule: “it does not necessarily follow that evidence of profit sharing compels a finding of partnership formation.”

Cautionary tale: this could have gone the other way. RUPA doesn’t say how to weigh the § 202 factors.o Don’t use the word partner unless you really mean it, make sure that the nature of the

relationship is so clearly defined that the issue doesn’t come up at all, plan for operation AND termination of partnership

6. Young v. Jones (D.S.C. 1992) – Partnership by Estoppel Plaintiffs relied on audit letter from PW-Bahamas in depositing money with a South Carolina

bank. The audit was falsified, they lost their investment, and because they assumed that PW-B was related to PW-US they wanted to collect from PW-US.

Could PW-US be considered in “partnership by estoppel”? NO.o No partnership in fact, but by estoppel? NO.o South Carolina law required that plaintiffs ‘extend credit’ to PW-Bahamas in reliance on

its relationship with PW-US. In this case, since the plaintiffs were not clients of PW-Bahamas, they could not hold PW-US liable under a theory of partnership by estoppel. Note that this case was decided on contract grounds (privity) and did not reach the

question of whether PW-US would have been liable if the plaintiffs had been clients of PW-Bahamas.

o Also, no evidence that Ps relied on any act or statement by any PW-US partner which indicated existence of partnership with PW-B

o Siegel : The court is asking the wrong question. Proper question is whether PW intended to clothe every one of its subsidiaries with its reputation in order to get more business. This holding would never be repeated in today’s climate. If you represent an organization that’s identified with a partnership, you’ll be liable most of the time. This was a surprising holding since PW does really hold itself out as an international

partnership As a general rule now, post-Enron etc, courts will hold that where there’s a general

representation to the public as a partnership, they will find partnership by estoppel

X. Fiduciary Obligations of Partners

1. General Observations Fiduciary duty (trust) can be divided into:

o Negative obligations (e.g., non-competitiveness)o Affirmative obligations (e.g., to account over for benefits)

Duty of care, despite RUPA, is not a fiduciary duty There are varying standards of care, levels of fiduciary obligation for different enterprises –

want them to do different things, act for different purposeso Partner in a business partnership – trying to make a profit, partners are supposed to take

risks to do soo Corporate exec in corporate settingo Trustee in a trust – NOT supposed to take risks, just supposed to protect assets

Stronger obligation to preserve assets, apply a higher standard of careo All ties in with the morality of the marketplace – compliance, disclosure, fair dealing,

profit maximization 2. Revised Uniform Partnership Act (RUPA)

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§401. Sets out default rules. This is a central provision of the RUPA and courts take it increasingly seriously. Be prepared to think critically about its advantages and disadvantages.o §401(b) sharing profits and losseso §401(f) equal rights in managemento §401(h) partner can only get remuneration for winding up (i.e., cannot collect salary in

addition to partnership interest)o §401(i) unanimous consent of all partners required for bringing in new partnerso §401(j) ordinary decisions are by majority of partners; extraordinary decisions must be

unanimous §403. Partners have a right to inspect the books and records of the partnership. §404. General Standards of Partner’s Conduct (Fiduciary duties):

o §404(a) Only duties partners owe the partnership are duty of loyalty and duty of care defined by §b and c.

o §404(b) Duty of loyalty requires partner to account to partnership for profits, property, including the appropriation of a partnership opportunity, etc.; to refraind from dealing with partnership as or on behalf of a party with an interest adverse to the partnership; to refrain from competing before dissolution.

o §404(c) Duty of care requires refraining from gross negligence, reckless conduct, intentional misconduct, or knowing violation of the law.

o §404(d) Requires good faith and fair dealing when exercising rights vis-à-vis the partnership.

o §404(e) Partner doesn’t violate these duties just because conduct furthers his own interest. As long as it’s not adverse to the partnership…

3. Meinhard v. Salmon (N.Y. 1928) (Cardozo) – Fiduciary Obligations of Partners M and S had a joint venture on 42nd Street. Near the end of the 20-year lease, manager S

entered into 80 year agreement with owner without telling M about it. M claimed that the new lease was property of the venture.

Did S’s lack of disclosure breach his duty of loyalty to the venture? Fall below standards of loyalty that are “stricter than the morals of the marketplace” owed to co-partner? YES.o The opportunity for the new lease came about as a result of the partnership enterprise.o As the managing partner, S owed a particular duty to his other partner and should have

disclosed the new opportunity to M, so the latter could have competed for the new lease. But would disclosure have allowed him to go ahead with the plan? Not sure. Might

have since there was an expiration point for the venture “we do not need to say whether he would have been under a duty, if successful in

the competition, to hold the lease so acquired for the benefit of a venture then about to end”

Had to at least share the chance B/C S put in more effort/actual participation, it might seem fair to allow him to take

the opportunity, but his position required him to think for the partnership first, “the rule of undivided loyalty is relentless and supreme”

o Partners can agree to some variations in the fiduciary duties owed each other, but there is a baseline Duties are also limited by the scope of the venture – another reason to make the

agreement clearo Remedy – forced S to extend to M an interest in the new lease – VERY harsh remedies

for breaching the very important fid duties… Conception of fiduciary duties

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o “joint adventurers, like co-partners, owe to one another, while the enterprise continues, the duty of the finest loyalty”

o There are set standards, which a stricter than the morals of the mktplace, that courts have not been willing to and will not lower – though perhaps an overstatement fiduciary principles are strong but not rigid, can be altered if equities demand

Lessons from this case:o Respond honestly to initial questions, or at least have a strategy for answering the

question (e.g., evasion, stonewalling)o Write something into the partnership agreement concerning an exit strategy.o Partnership Opportunity Obligation - obligation to give to an existing partnership those

benefits which arise and are presented to the partner as part of his conduct in the carrying on of the business Tied to §404 – account for benefits arising out of conduct of partnership If opportunity arises from conduct of current partnership partner has duty to

account for and share that opportunity with the partnership But if the new opportunity isn’t really related to the current venture, it’s different.

Siegel : Joint venture, not a partnership, because time limited and lease/property limited. Thinks the holding is wrong (b/c remedy holds parties to 80-year lease clearly not contemplated in joint venture agreement), but notes that S made a big mistake by keeping M uninformed. o In line with dissent – would agree w/ holding if this had been a formal partnership, but

can relax the rules when it’s only a joint venture that was limited in time, objectives, purposes… only owe loyalty w/i the scope of the venture

o Courts don’t like it when partners deny other partners information or give them misinformation.

o When it comes to fiduciary duties, we read the statute broadly. Siegel : To avoid this situation, the parties should have specified up front (in their agreement)

that this was a joint venture, not a partnership, due to end in 1922. o Also, they could have specified that the parties could enter into other leases that would

have no effect on this agreement. Agreements can outline what won’t be a violation of the loyalty duties or standard of care Contractually adjust the basics of the business association §103(b)(3) – recognition that the broad fid obligation can be adjusted by the parties

4. Bane v. Ferguson (7 th Cir. 1989) (Posner) – After Dissolution, Duty of Care Retired partner claims negligence on the part of the managing council when he loses his

pension upon dissolution of the firm Was former partner owed fiduciary duties after departure? Could he sue for breach of those

duties and the termination of his retirement benefits? NO, no standing, and not owed duty of care because no longer a partner.o A partner is a fiduciary to his partners, not his former partners. o RUPA protects partners, not former partners or 3rd partieso Even if Ps owed him a fiduciary duty, the business-judgment rule would shield them

from liability for mere negligence. The real problem here was negligent mismanagement of the firm, not of his interests

Consequences – these cases are hard to prove individually, there are now regulations for these issues re: pension plans, ERISA…

Lesson: 1) Never rely on an unfunded pension plan; 2) when you leave a partnership, get the money as quickly as possible. Former partners are considered quasi-partners: under partnership law, other creditors of a partnership always take priority over other partners and quasi-partners who are creditors.

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5. Meehan v. Shaughnessy (Mass. 1989) – Grabbing and Leaving, Duty of Loyalty Attorneys at Parker Counter wanted to leave, start their own firm, and take some clients with

them.o They did disclose the fact that they were leaving, but were secretive concerning which

clients they intended to take, overly aggressive in planning to obtain clients’ consent, and disloyal in the substance and method of communicating with clients.

Did they breach their duty of loyalty by convincing clients to come with them without properly informing them that they had the right to stay with the firm and without disclosing to the firm in a timely manner the list of clients they intended to take and by lying when asked about their plans to leave? YES.o Partners owe each other a fiduciary duty of “the utmost good faith and loyalty” and

partners “must consider his or her partners’ welfare, and refrain from acting for purely private gain”

o Fiduciary duty includes full disclosure of all matters affecting the partnership – obligation to “render on demand true and full information of all things affecting the partnership to any partner” They lied when asked…

o It is okay to plan for competing against former partners, and to take steps such as setting up the physical space of their future office. They didn’t breach the non-compete duty. Can make plans to compete, but can’t act in violation of current fid duties

o It is a breach of duty to obtain an unfair advantage in competing for current clients while still a member of the partnership. They did unfairly acquire consent to remove cases. Can’t sneak around to grab clients before leaving – had a duty to disclose

Siegel : If you are asked whether or not you are leaving, you should say, “No comment.” You CANNOT make a false statement of material fact. These guys made the mistake of lying and of jumping the gun by contacting clients before telling the partners.

Siegel : You can’t rely on this case for much. It’s not always the case that partners can just leave and take their clients with them – this opinion is permissive. It’s difficult to write an agreement to include an exit strategy: the difficulty is that when people collectively write an agreement like this, the more specific they get, the more restrictive they get. An agreement with really unfavorable terms is worse than no agreement at all. It’s human nature to assume that it’ll be the other guy who wants out.

6. Lawlis v. Kightlinger & Gray (Ind.App.1990) – Partner Expulsion One partner with alcohol problem. Partners voted to expel him even though he had not

relapsed into alcoholism, pursuant to the expulsion terms of the partnership agreement. Did the firm violate any duty to Lawlis by expelling him? NO.

o They had the majority vote, all that was needed, to oust him. o An expulsion, even under the terms of a partnership agreement, is invalid if it is

conducted in bad faith or for a predatory purpose – but this wasn’t When a partner is involuntarily expelled from a business, his expulsion must have

been “bona fide” or in “good faith” for a dissolution to occur without violation of the partnership agreement.

There was no bad faith or predatory purpose for the expulsion, therefore it is valid. They treated him fairly - had given him a 2nd chance, 8 months to find a new job while still officially acting as a senior partner

o Breach of a more general fiduciary duty to exercise good faith, fair dealing towards partners? No. those duties relate to the business aspects, partnership property, terms of the partnership agreement – the actions were consistent with that

General rule for lawful expulsion: “Where the remaining partners in a firm deem it necessary to expel a partner under a no cause expulsion clause in a partnership agreement freely

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negotiated and entered into, the expelling partners act in good faith regardless of motivation if that act does not cause a wrongful withholding of money or property legally due the expelled partner at the time he is expelled.”

Lessons from this case:o Law firms need expulsion arrangements without cause. Otherwise, you will definitely

end up in court. (might anyway if the expelled partner argues that the expulsion was not in good faith) Risk – puts everyone at risk of expulsion for no cause

o One way of doing this while protecting partners is to give leaving partner a substantial monetary award. – restrain partnership from exercising expulsion option by making expulsion costly for the partnership When there is cause, you could possibly provide no money – then you have to prove

cause, but you at least have the option. Prevent random expulsions by tying it to a monetary penalty or provision on the

partnershipo Try to structure the agreement so that it’s better for the partner to leave on his own (even

if “encouraged”) than to be expelled

XI. Partnership Property and Management Rights

1. General Observations Partnership Property

o If property is conveyed into a corporation by a shareholder, the corporation owns the property and the shareholder has stock. Shareholder has no right to possess the property

o But if the property is conveyed into a partnership, partner gets an increase in his capital account equal to the value of what was conveyed to the partnership, and an ownership interest equal to what’s been contributed.

o 3 components to a partner’s interest in a partnership Ownership interest in capital or assets of partnership Interest in profits and losses of partnership Interest in the control or management of the partnership – voting rights, etc These rights/interests are disaggregated – not every partner has all rights, all depends

on terms of the partnership agreement Partnership capital accounts – RUPA §401(a) – The ownership interest is the dollar amount

in the capital account, NOT a percentageo Each and every partner has a separate capital account tracing ownership interests in the

partnershipo Partner doesn’t get cash unless it’s distributed from the partnership

Distributions generally governed by the partnership agreement, subtracted from value in capital account

o Allocations made into the account are immediately income, even if not actually/immediately distributed as cash Profit share will typically NOT match up with effective percentage ownership of

property as a wholeo Example: Overall description of partner’s capital account

Joined with an initial contribution of 500,000 Plus profits (share of profits) – profit share of 200,000 total of 700,000 Minus distributions (cash) – paid out 150,000 total of 550,000 Minus losses (share of losses) – if she bares 20% of total 100,000 partnership loss

subtract 20,000 530,000 in account total

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o Managing the capital account (allocation, distribution, etc) is an extremely important, sensitive area – dealing with people’s money, need to make sure the agreement is particularly clear Partners generally recoup all interest when the partner leaves or when the partnership

dissolves – rather than cashing out in the middle Ultimate pay-out – At dissolution,sell off all assets and allocate interests according to

the capital account structure and pay out the balance of the accountso Comparison w/ corporate ownership interests – divided into shares of stock

Multiple classes – common and preferred stock Holders of both get a fractional amount of corporation’s profits, based on the number

of shares held Much more difficult to divide profits in other ways – proportional distribution is a

strong presumption Profit Allocation – How can profits in a partnership be divided? Never has to be an all or

nothing thingo Seniority o Accounts brought in, business generation o Performance – judged by a variety of factors(much more flexibility for partnerships than

for corporations) Hours worked Billables Ratings of the product Benefits – merit based seems fair, prevents slackers from free-riding, creates

incentives to work hard Risks – tends to produce a somewhat higher incidence of fraud, overbilling,

overrecording or wasting of time, some detrimental cultural/social consequenceso Equality – could divide up the shares equally – that’s the RUPA default, what happens

unless/until there’s a specific agreemento Capital contribution – most used for the corporate setting, less important in the law firm

settingo Leadership position/roleo Variable profit shares – partner’s interest can be negotiated each year

Adds flexibility Follow some system for changing, evaluating percentages Different percentages for different income streams – i.e., operations profits divided in

one way, sales profits in another…o Mechanisms for dividing profits

If we’re dividing profits by capital contributions – we can divide based on fractional, proportional or percentage share 10% contribution 10% interest in profits, divide in proportion

Can also be used as a mechanism for performance-oriented distribution Any allocation based on financial criteria can be calculated on a fractional basis Problem – it might not reward efficiency, it might reward time – the problem with

billable hours Raising Additional Capital

o Can call for contributions from the partners, threaten to reduce shares of current partners who do not contribute (pro rata dilution)

o Penalty dilution – don’t actually cut back on your interest, but everyone who contributes gets more

o Can ask for partners to make loans to the partners

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o Or selling new partnership shares to new partners, and bringing money in that wayo What happens when a partner is added?

Current partners could take a uniform reduction, but that wouldn’t be popular Switch to the unit system, instead of a percentage system

Add units, devalue everyone’s interest, but the numbers don’t go down Nominally, existing partners don’t lose out when new partners are added –

superficially, their numbers don’t change Is a very fair method – everyone is affected in direct proportion to their existing

ownership interest Units are also frequently associated with capital contributions – when you get

more units, it’s expected that you’ll contribute Management Rights

o Right to participate in the operation of the business in some way is an implicit term of the partnership agreement

o UPA Default management (§18(e)) – all partners have equal rights in the management and conduct of the partnership business”

o Default voting rule – Majority vote of partners controls for ordinary business operations.o Decisions outside the ordinary course of business, i.e. amendment to partnership

agreement, merger, need unanimous vote of all partners2. RUPA Sections:

§203. Defining the Property Rule §204. Evidentiary rules concerning partnership property

o Checklist for determining partnership property §401 (what section) – Management rights - In the absence of an agreement, each partner has

equal rights in the management of partnership business. §401(a) – What it means to make an investment in a partnership, and the resulting

presumptive ruleso Each partner is deemed to have an account that is credited with an amount equal to the

money value plus the value of any other property net the liabilities which the partner contributed to the partnership

§401(h). Partner is not entitled to remuneration for services provided for the partnershipo Any effective salary comes out of yearly allocation to capital accounto Distributions are drawn against profit allocation ultimately given

§401(j) – Voting rights §§501-03. Transferring Partnership Property and Interest:

o §501. Partner is not a co-owner of partnership property, has no interest in partnership property that can be transferred

o §502. Only transferable interest of a partner in the partnership is the partner’s share of the profits and losses of the partnership and the partner’s right to receive distributions. The interest is personal property. The partner’s interest is the profit interest plus capital balance

o §503. A transfer is permissible, does not by itself cause the partner’s dissociation, and does not entitle the transferee to rights of management or participation in partnership’s business.

3. Putnam v. Shoaf (Ct. App. Of Tenn. 1981) – Partnership Property Mrs. Putnam conveys her interest in the partnership to the Shoafs. Later discovers

embezzlement during period of her involvement, and wants to collect a share of the damages. Can she collect? NO, she is no longer a partner, has fully conveyed her partnershiop interest,

has no remaining interest in the property…

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o Property acquired by the partnership is the property of the partnership and not of the partners individually Possessory right is incident to the partnership and does not exist absent the

partnership – right goes with the partnershipo A partner does not have any rights to specific partnership property. The partnership

interest is an undivided interest, like a joint tenancy. Why property is conveyed in the name of the partnership rather than the partners.

o Thus, if the partnership had an unknown asset at the time of the transfer of partnership interest, such as an untapped oil reservoir or a legal claim, the former partner has no right to it.

o And once partnership rights are transferred, once she was completely released and discharged from all liability, debts, involvement, she has no more claim on partnership property

Case seems to support the entity theory of partnership against the notion that a partner can have an individual claim against a third party for damages to the partnership. RUPA §203

Characteristics of partnership property - property but can’t keep the proceeds; creditors of partners can’t get at partnership property, although they can get an order against a partner’s partnership interest (share of distributions and proceeds upon winding up).

4. National Biscuit Company v. Stroud (N.C. 1959) – Management Rights, Deadlocked partnership. Deadlock in a two-person partnership, where nothing in the partnership agreement indicated

restrictions on management rights. Stroud tells NBC that he won’t be responsible for any bread sold to the partnership

What happens when there’s no majority vote between partners on ordinary issues? Can partners limit the power to manage the partnership, act in the ordinary course of business? NO. Can the actions of one partner bind the partnership? YES (regardless of the benefit for the partnership), unless in contravention to actual restrictions in the partnership agreement.o One partner can’t deny another equal partner power to bind the partnership, can’t destroy

a partner’s right to act in the ordinary course of business without restrictions in the partnership agreement, even with notice to outside world deadlocks can’t stop decisions.

o The partnership is bound by the actions of a partner unless a 3rd party had notice of lack of authority AND partner actually lacked authority No act of a partner in contravention of a restriction on authority shall bind the

partnership to persons having knowledge of the restriction. But if no restrictions actions are binding

o § 301(1): Each partner is an agent of the partnership for the purpose of partner ship business. A partnership is bound by the act of a partner unless the partner had no authority to act for the partnership and the person with whom the partner was dealing had received notification that the partner lacked authority.

o § 401(f) and (j): each partners has equal rights in the management and conduct of partnership business” and “a difference arising as to a matter in the ordinary course of business of a partnership may be decided by a majority of the partners.”

Rule: When there are only 2 partners, there can be no majority – one partner can’t deny the other the authority to conduct ordinary businesso “The partnership being a going concern, activities within the scope of the business should

not be limited, save by the expressed will of the majority deciding a disputed question; half of the members are not a majority”

Lessons from this case:

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o Very important to have a dispute resolution mechanism in the partnership agreement. I.E. Resolution (mediation, negotiation, etc.), Buy-out (dissociation), Dissolution (winding up) of the partnership.

o Maybe change the default majority vote rule or put in place provisions allowing partners to limit the authority of other partners…

5. Summers v. Dooley (Idaho 1971) – Management Rights Summers, against Dooley’s prohibition, hired a third employee and paid him out of

partnership funds. Partnership agreement said that the two men would operate the business, but if either couldn’t work, the nonworking partner would provide a replacement at his own expense. S tried to get reimbursement for the expense from partnership funds.

Is the partnership responsible for the costs? NO. Summers can’t collect from Dooley because a majority of the partners didn’t agree to hiring the 3rd man.o Because Dooley made active and repeated objections (more than silent non-consent), the

employee should not have been paid out of partnership funds.o Just because D may have benefited through the partnership by the expense doesn’t mean

he needs to pay for ito Needed a majority to approve the expense in order to bind the partnershipo Underlying concern – can’t allow one partner to take advantage of the other, and the

partnership, for personal benefits This shows that equal partner cases can go either way. The outcome here was the opposite of

National Biscuit. – case decided on the equities… uncertainty makes planning more important

Underlying problem – how to deal with disagreements in a 2-partner partnership, when there may not be a majority or unanimity? How do we address the problem of management deadlock?

6. Day v. Sidley & Austin (D.D.C. 1975) – Management Rights Sidley was merging with another firm. Plaintiff was a partner at Sidley and chairman of the

firm’s DC office. According to P, the firm had decided to appoint a co-chairman of the DC office without telling him, and the info would have affected his vote on the merger.

Does he have a cause of action for fraud or breach of fiduciary duty? NO. Did he have a contractual right to remain the sold chairman of the DC office? NO.o Nothing about the chairman position was in the partnership agreement so no legal right

about which there could have been a misrepresentation; the essence of a breach of fiduciary duty between partners is that one partner has advantaged himself at the expense of the firm – no evidence of that here.

o There was no mention of a right to any position within the firm in the Partnership Agreement. And he was never given unconditional control over the office, it was controlled by another committee.

o Other partners had no fiduciary obligation to maintain plaintiff in his position as sole chairman of the DC office. “essence of a breach of fiduciary duty between partners is that one partner has

advantaged himself at the expense of the firm” – this didn’t happen here there is no fiduciary duty to reveal info re: internal changes in the firm

Here, the partnership agreement seemed to work – didn’t give Day the rights he wanted, so court wouldn’t infer them, and it did authorize a merger in the way they did it, so the consequences of the merger didn’t violate anything eithero Underlying message – if you don’t write a partnership agreement, court will impose

normal standards from UPA. But if you do write an agreement, court will read it literally. (unless there’s a manifestly inequitable result)

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o Lesson #1: In partnership law, partners are free to make any agreement that suits them, without concern about niceties of partnership theory, and its illustration of the principle of contract law.

o Lesson #2: Provide up front for a severance package. Even a powerful partner is vulnerable in this type of situation. There’s no such thing as tenure. It is always best to make clear the nature of the relationship up front: payments, responsibilities, fees, etc. There is a substantial likelihood that the other party doesn’t have the same expectations that you have. You’re almost always going to be disappointed.

XII. Dissociation and Dissolution

1. General Observations Termination of partnership – how can you terminate the actual authority of a partner to act on

behalf of the partnership?o Can’t terminate a partner’s authority without getting rid of the partner – if still a partner

still has authority/agency for the partnershipo Voluntary terminations always better than forced terminationo Can also close down the partnership entirely – dissolution

There is a terminology change between the old UPA and the RUPA:o Old UPA. Dissolution is changing of relationships as a result of a partner leaving a

partnership. Winding up is closing everything down and sell assets.o RUPA.

Dissociation - same as old dissolution – i.e., when a partner or partners leave the partnership. §601 If one partner dissociates, does that trigger dissolution of the partnership entirely?

It can, but it doesn’t have to… Dissolution is the full winding up process like before. §801

Rightful v. Wrongful Dissolution/Dissociationo Rightful – without violation of the partnership agreement, i.e. partnership for a term or

partnership at will If there is no specific term for dissolution at all, every partner may withdraw when he

wants, leaving won’t be illegal, can trigger a winding up if the other partners want Expulsion, depending on the terms of the agreement, can also be rightful

o Wrongful – dissolution in contravention of the agreement, where the circumstances do not permit a dissociation of any partner at any time

Expulsion - there is no statutory right of expulsion. RUPA does allow for cases where a disbarred attorney may be expelled.o RUPA allows for a judicial process on expulsion. This would be an equitable hearing on

the merits. Judge may deny the course of action if she thinks it is not equitable.o One alternative to expulsion is to create term partnerships that require renewal.o Partnership agreements that provide for ouster for cause are bad because they would

almost definitely have to go to court. Better to have general at will ouster provisions. Agreements without ouster provisions need to force dissociation inevitably lead to litigation

RUPA requires that there be notice of the dissociation to the other partners. Buyout Agreements: agreement that allows a partner to end his relationship with the other

partners and receive a cash payment, series of payments, some assets of the firm in return for his interest in the firm. Need to tailor it to the situation, but there are basic issues that are generally addressed:o Trigger events – death, disability, will of any partner

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o Obligation to buy v. Option to buy – firm, other investors Consequences of refusal to buy – if obligated, if not obligated

o Price – book value, appraisal, formula (i.e. five times earnings), set price each year, relation to duration (i.e lower price in the first 5 years)

o Method of payment – cash, installments (with interest?)o Protection against debts of partnershipo Procedure for offering either to buy or sell – First mover sets price, first mover forces

others to set price2. RUPA

§§601-03. Two general ways to dissolve a partnership: (though best possible solution to these issues is a well-drafted partnership agreement)o §601 – Dissociation

Upon express notice of partner’s intent to dissociate – the partnership has to make clear to the partnership

Certain events trigger dissociation – partner’s death, legal bankruptcy, etc Expulsion - can be done by judicial determination under certain circumstances

Courts are sitting in equity, so partnership has to prove that the questionable events took place and that the court “ought” to expel the partner because of them

o §602 – Any partner may dissociate at any time, rightfully or wrongfully, by express will pursuant to §601 Partners can always get out, because partnership creates a presumptive set of

relationships, agencies, etc, that we can’t impose on people. Can’t impose the agency/liability connection on partners who don’t want to be connected

Can’t force someone to be a partner, though can make them pay a price for getting out, may be able to prevent them from doing certain things afterwards

Violation of Agreement: this is called ‘power’ of dissolution. Damages, equity, etc. might apply. If partner dissociates in violation of an express provision or prior to set

expiration, partner will be liable to partnership for damages caused by his dissociation

Not in violation: if there is no definite term, the partnership is ‘at will.’o §603. Effect of dissociation on other partnership obligations

Partner’s right to participate in management terminates unless otherwise specified Fiduciary obligations going forward are terminated Duty of loyalty under §404 continues only with regard to events arising before the

dissociation, unless the partner continues to participate in the winding up, so the obligations extend to that too

§701. Payment of Withdrawing Partner’s Interest (Art. 7 – dissociation of one partner, continuation of the partnership)o §701(a). Must pay off leaving partner. Amount is what would have been distributed to a

partner if the partnership were liquidated. This is related to each partner’s capital account. Presumption that partner’s interest gets bought out at fair value of interest minus

damages from dissociation o §701(b). Creates a default low-end value for a liquidated partnership.o §701(c). Damages should be offset against the buy-out price. And if no agreement for

buy-out is made within a certain period, the partnership should pay in cash the amount estimated to be the buy-out price – meant to prevent partnership from stalling

§§801-03. Winding Up Partnership Business

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o §801(1-2). In a partnership at will, a partnership is dissolved after any partner gives notice. In a partnership with a definite term or for a particular undertaking (this must include law firms), a partnership can be dissolved by a majority vote within 90 days after a partner’s dissociation.

o §801(5). Judicial winding up due to frustration of economic purpose of partnership or not reasonably practicable to carry on business.

o §802. After decision to dissolve the partnership, it remains an entity during the winding up period, until its business is completed. Then the partnership is terminated.

o A partner, for good cause, may request judicial supervision of the winding up.o Absolute right to a winding up is conditional about the court’s approacho Appears on the face that there can be a winding up whenever the partner is not illegally

or improperly leaving the partnership, but there’s also a possibility that the court will keep the partnership together

3. Owen v. Cohen (Cal 2d. 1941) – The Right to Dissolve Bowling alley partners can’t get along, so one asks the court to dissolve the partnership and

sell its assets. Can there be a judicial dissolution? Did evidence warrant a decree of dissolution? YES.

o Court agreed to dissolve the partnership because the bitter, antagonistic feeling between the parties was such that they were incapable of carrying on the business to their mutual advantage. They disagreed on almost all matters of policy relating to the operation of the business Cooperation was necessary given the nature of the partnership and it was impossible Emphasis on the equities involved, making an equitable decision

o RUPA § 801(5): A partnership is dissolved on application by a partner, by a judicial decree that: (i) the economic purpose of the partnership is likely to be reasonably frustrated; (ii) another partner has engaged in conduct relating to the partnership business that makes it not reasonably practicable to carry on the business in partnership with that partner; or (iii) it is not otherwise reasonably practicable to carry on the partnership business in conformity with the partnership agreement. (though relied on UPA §32 in the opinion)

Why did Owen bring this case to court? Because he didn’t want to try for dissolution and have Cohen to call it wrongful dissolution and go to court for settlement. This was under the old act, so pulling out on his own would have been a problem.o Remember that bringing an action is not itself an act of wrongdoing.o Wrongful disassociation: A partner always has the power to dissociate, although not the

right. A partner’s dissociation is wrongful if it is a breach of an express provision in the agreement or before the expiration of the term. Wrongfully dissociating partner is liable to partnership and other partners for damages caused by dissociation – comes out of his buyout $$.

Problem – this led to the termination of the entire business. How can you keep the business but not the partnership together?o Competitive bidding system - Agreement could have a provision that provides partners

the option of demanding a winding up and an auction. o Highest bidder (former partners are eligible) gets the business – so you get both the end

of the partnership and the continuation of the business if desired…4. Collins v. Lewis (Texas Ct. of App. 1955) – The Right to Dissolve

Collins was money man; Lewis was manager. Together they formed a partnership for a cafeteria, each considered to have 50% interest. When costs became excessive, Collins filed for a court-mandated dissolution, because he felt the business would never be profitable.

Can there be a judicial dissolution? NO.

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o Court distinguished between power to dissolve and right to dissolve. One always had power, but if one didn’t have a right, then one would be responsible for damages.

o Court will not dissolve partnership because it thinks that P is trying to use his money and power to take advantage of D. If either party wants out, he has the power to leave; he’ll just be liable for any damages his dissociation causes

o Evidence of unprofitability indicates P was somewhat at fault – Lewis was doing his party, holding up his end of the deal sufficiently, and Collins was trying to foreclose on the partnership anyway.

Practical considerations - By refusing a judicial dissolution, the court would force Collins to either pay damages or buy out Lewis’s share of the partnership.o Keep business in business, but not necessarily forcing them to stay in an unprofitable

partnership, just making them figure it out/pull out on their own. Underlying equitable concerns: When the court is made aware of the equities, it usually

won’t ignore them. Court didn’t want to use judicial remedy if it would have inequitable results

5. Page v. Page (Cal 2d. 1961) (Traynor) – The Right to Dissolve Partners were brothers. For years they had lost money in their business. Their major creditor

was a corporation wholly owned by the plaintiff. Once the business started making modest amounts of money, the plaintiff wanted to dissolve the partnership, sought declaratory judgment that partnership was not for any definite term and therefore could be dissolved at will. Lower court implied a term for the partnership.o Note that the plaintiff would have benefited from the dissolution because as a creditor he

would have been entitled to the assets of the partnership. Can there be judicial dissolution? Can the court infer some term limit for the partnership so

that dissolution would be wrongful and there might be a remedy? NO.o Traynor ruled that the partnership was “at will” and therefore a party could unilaterally

dissolve it by providing proper notice. Nonetheless, the power to dissolve could not be undertaken in bad faith and therefore the court should refuse to recognize a proper dissolution. Not going to imply a term based on some sort of loan recoupment period, here the

expenses were just designed to be recouped through income. This was just a general hope to make profits

There was no evidence that the partnership was designed to last for the term necessary to pay debts, repay loans, recoup investments, etc

o “A partner may not dissolve the partnership to gain the benefits of the business for himself, unless he fully compensates his co-partner for his share of the prospective business opportunity. Sounds like Meinhard v. Salmon – discussion of potential bad faith efforts to

appropriate the now profitable business The buyout price must include not just the value but the expectation of future profit.

If he tries to buy out his partner without adequate compensation, the dissolution will be wrongful.

o Court is respecting the fact that this is a partnership at will – have fiduciary obligations, but not beyond the point that it is an at will partnership. There’s no debate about continuing a partnership when there’s nothing compelling its continuation

Note: Can’t square Page and Owen except on the equities. [why?] Siegel : This goes beyond the language of RUPA. California leads the country in broad

reading of fiduciary duty – case wouldn’t come out this way in other jurisdictions.

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o Here, the fiduciary duty to continue the partnership as agreed or to dissolve at will according to agreement overrides their right to have the court break up the business. Duty not to use the courts system to their advantage? What is this about?

6. Prentiss v. Sheffel (Ariz.App. 1973) – The Consequences of Dissolution In a three person partnership at will, 2 partner/plaintiffs had shut out the defendant from

management of the partnership, and sought court-supervised dissolution sale of the business. Trial court granted dissolution and auctioned off business.

Can they then bid for the partnership at auction? YES. Purchase was allowed and not in bad faith.o Their purchasing the business does not injure D – who will get more money because

interested parties are actually buying All former partners benefit from sale to the highest bidder, at the highest price Preventing the most interested party from participating would hurt them all He could have participated in the auction too

o They did not freeze him out for the purpose of taking over the business, but because they didn’t get along (part of the reason for his current personal attack – not challenging the judicially mandated sale, but just their ability to participate)

7. Monin v. Monin (Ky.App.1989) – Consequences of Dissolution In milk hauling partnership between brothers, one brother [Sonny] expressed intention to

dissolve partnership. He notified their major contract of the expected dissolution and simultaneously applied for the contract after dissolution. The partners held a private auction and the other partner [Charles] purchased the partnership’s assets. Nonetheless, Sonny received the milk contract, because the contracted company would only approve him.

Did Sonny violate his fiduciary duty to the partnership by interfering with the partnership’s contractual relations w/ customers? YES. Sonny had duties to the partnership w/ respect to its major assets.o He had a continuing obligation to the partnership during the winding up period, which

included following through on his agreement to sell his interest to charles should have withdrawn his application

o Elements of grabbing and leaving – when there’s one major asset at issue, courts will look carefully for hints of Meinhard-esque overreaching

o Siegel : Sonny’s conduct in speaking with DI is so bad that it constituted a breach of fiduciary duty and the court should have provided an additional damages assessment. Problem – was this (should this have been) really a breach of contract case? The

egregious-ness seemed to push it over the edge General Rule: One partner can not benefit at the expense of the partnership Dissent – not really a breach, and the producers wanted to work with Sonny not Charles. What advice do you give in a situation like this? To the partner who is really responsible for

the business…o Dissolve the partnershipo Figure out the partnership first. Then compete for and arrange the contracto It’s much worse to set up the deal first, behind the back of the other partner triggers

presumptions of unfairness, violation of fiduciary obligations8. Pav-Saver Corporation v. Vasso Corporation (Ill.App.1986) – Consequences of Dissolution

Partnership agreement stated that license for certain patents would revert to plaintiff following dissolution.o Agreement contemplated mutual dissolution, but provided for liquidated damages in the

case of a unilateral dissolution. What are the consequences of dissolution? Plaintiff had engaged in a wrongful dissolution

which notwithstanding the Partnership Agreement would be governed by the default rules of

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the UPA. Wrongful dissolution triggers UPA rather than partnership agreement (despite what agreement laid out)o Old UPA says that w/dissolution in contravention of agreement, UPA controls and

partners that did not cause a wrongful dissolution are entitled to continue the business. Thus, the defendant could keep control of the patents.

o Court says they must pay liquidated damages (4x), per agreement, but say that provision that the patents will be returned to PSC upon dissolution of partnership is unenforceable. Even though the contract interpretation would be that if the agreement is wrongly terminated, the liquidated damages provision should be the only penalty, the court says PSC has to pay liquidated damages AND the partnership gets to keep the patents

Siegel : This is an ‘outrageous’ situation. Contract contemplated unilateral termination and provided for liquidated damages. However, the court imposed additional damages. Agreement should have totally controlled, this is why you don’t want cases decided by a court.o Dissent – the UPA only controls when there’s no partnership agreement, here there was

and it covered the disputed issues. Partnership agreement should have controlled. Lesson: Should have written a separate clause into the agreement specifying what clauses

apply upon termination of partnership. Need to think through and include instructions for how the partnership agreement is actually supposed to be carried out.

Note: §701 of UPA imposing a punitive provision concerning value of goodwill at dissolution of partnership has been eliminated.

9. Kovacik v. Reed (Cal 2d. 1957) – Sharing of Losses K and R entered renovations partnership. K offered to put up money if R would superintend

the jobs, and that they’d share the profits equally. No mention was made about sharing losses. K provided all financing, and when he realized business had lost money, demanded that R contribute to the losses. R claimed he never agreed to be liable for losses.o Trial court inferred agreement to split losses.o Intangible assets are traditionally considered part of a partner’s capital account. Kovacik

says that this should go one step further and contributions of labor after the establishment should also count. [but why should this affect distribution of profits and losses? I thought capital accounts didn’t matter for these.]

Should the losses be shared? How? Equally, like their initial contributiono General rule: in the absence of an agreement to the contrary, the law presumes that

partners intended to participate equally in the profits and losses of the common enterprise, irrespective of any inequality in the amounts each contributed to the capital employed, with the losses being shared in the same proportion as the profits.

o BUT in cases where one partner contributes all the money against the other’s skill/labor, courts hold that neither party is liable to the other for contribution to losses partner who contributed money is not entitled to recover any of it from the partner who only contributed services (as long as he didn’t also collect compensation) Each should lose his own capital

o Even though the agreement was silent as to losses, the fact that the partners agreed to share the profits 50-50 suggests that Reed’s labor was thought an equal contribution to Kovacik’s money. So they both lost the same amount already.

UPA provisions that controlled this:o §18(a) – Each partner shall be repaid his contributions whether by way of capital or

advances to the partnership property and share equally in the profits … and must contribute towards the losses, whether capital or otherwise sustained according to his share in the profits

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o § 40(b) – how liabilities of a partnership are paid following dissolution: 1) creditors other than partners; 2) partners’ loans; 3) partners’ capital accounts; 4) partners’ profits

Provisions and opinion seemed inconsistent, so RUPA 401(b) readopted the loss sharing provision: “Each partner is entitled to an equal share of the partnership profits and is chargeable with a share of partnership losses in proportion to the partner’s share of the profits” (Comment explicitly rejected Kovacik, stating that default loss splitting occurs even where one partner contributes no capital). o Ties into § 401(h) which considers services rendered in setting up the partnership as

capital contributions applied to a partner’s capital account. Siegel : Don’t rely on this case to save a no-money partner. Write it into the agreement that

he will not be liable for 50% of the losses, because it is still true that he won’t get remunerated for his services and that both partners are liable for the losses.

General Proposition: Loss gets allocated to capital accounts in proportion to the profit share, but is balanced against the actual amount in the account… When there are losses, they are paid against the capital accounts

10. G & S Investments v. Belman (Ariz. 1984) – Buyout Agreements Drug-using, sexually harassing partner who died. Partners sought judicial dissolution of the

partnership and the right to continue the business and buyout his interest.o Note: Bringing of an action to dissolve a partnership based upon claimed violation of the

agreement or claimed actions inconsistent with carrying on the partnership will not be itself a dissolution The filing of the claim, bringing of the action does not dissolve the partnership –

need the judicial decision to dissolve Though it might preclude the complaining party from alleging wrongful dissolution

Can the surviving partner continue the partnership after the death of the other, and how should his interest in the partnership be computed?o Partnership agreement said that surviving partners could continue the business, if they

purchased the interest of the other partnero Buyout Formula based on partner’s capital account – but problem b/c Nordale had a

negative actual balance but a positive FMV of the interest How to interpret? “The words ‘capital account’ are not ambiguous and clearly mean

the partner’s capital account as it appears on the books of the partnership” If partners want to use FMV, need to write that in agreement Otherwise, capital account refers to the records kept at cost, literal totals adjusted

over time Possible reasons the buyout was based on capital account as opposed to FMV: 1)

wanted to penalize partner who left; 2) thought the 3-year profit would offset the negative balance

o Defendant had a negative capital account because there was a write-off for depreciation (a loss), which is very common in real estate. Negative value wasn’t really representative of actual value of the interest, due only to

depreciation If a partner is expelled, he is penalized because he has a negative capital account. So, should

always ask when drafting agreement whether buy-out agreement has a rational result. General Rule: Partnership buy-out agreements are valid and binding although the purchase

price agreed upon is less or more than the actual value of the interest at the time of death. Lesson: the Court will enforce a buyout agreement if there is an agreement. You better

write what you mean. And make it fair, tied to actual value, and to an easily determined value. You may be the one wanting out

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o Buy-out provision concerns – defining the events (when and why someone will be paid) and defining the value (how much someone will be paid)

11. Jewel v. Boxer (Cal 3d. 1984) – Dissolution of Law Partnerships Law firm with no written partnership agreement dissolves, and there is a dispute over how to

divide up the post-dissolution proceeds from active cases How should these assets be divided?

o Attorneys fees received on cases in progress upon dissolution of a law partnership are to be shared with former partners according to their right to fees in the former partnership, regardless of which former partner provides legal services in the case after the dissolution.

General Proposition: partnership effectively remains intact until its final termination and no partner is entitled to extra compensation for services rendered in completing unfinished business.o Proceeds earned during winding up distributed as they would have been normallyo Kept in check by fiduciary duties that still apply during the winding up period – partners

still have a duty to wind up and complete partnership business and are restrained from taking actions purely for personal gain

Policy reason for rule that it encourages stability of business as winding up occurs. Prevents lawyers from competing for the most profitable cases during the life of the partnership in hopes of keeping them upon dissolution. Prevents scrambling for the big cases during the winding up.o Though court overlooked the more detailed, equitable approach applied by the lower

court Lesson: Partners should have had a written partnership agreement that specified what was to

be done upon dissolution of the firm Siegel : § 401(h) changes the rule of this case: “except for reasonable compensation for

services rendered in winding up the business of the partnership.” This provision allows a degree of equity in these circumstances

12. Meehan v. Shaughnessy – Dissolution of Law Partnerships Law firm partners leave partnership and breach fiduciary duty by wrongfully taking some of

their clients with them. What are the consequences of this dissolution?

o The partnership agreement detailed consequences of a partner’s departure. The carefully drawn up partnership agreement signaled intention not to be governed

by UPA default liquidation/winding up rules So upon the payment of a fair charge, any case may be removed regardless of

whether the case came to the firm through the personal efforts of the departing partner, though privilege to do so was dependent upon fulfillment of fiduciary obligations.

o Relying on express terms of the partnership agreement: a partner who separates his practice from that of the firm receives 1) the right to his capital account; 2) the right to a share of the net income to which the dissolved partnership is entitled; and 3) the right to a portion of the firm’s unfinished business, and in exchange gives up all other rights in the dissolved firm’s remaining assets

o MBC has to account to their former partnership for the profits that they make off the cases they took wrongfully. Profits from unfairly removed cases would be held in a “constructive trust” and distributed according to the shares of interest as they stood before the partners left the firm. But court did look behind this to the equities – the fiduciary violation in grabbing and

leaving in the first place allowed the court to ignore the terms of the agreement in

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other areas. Partners who receive profits from breach of fiduciary duty are responsible to the firm for more, for unfairly garnered profits.

They’ll still get what they would have gotten with the firm, but can’t claim the whole benefit for themselves.

XIII. Limited Partnerships

1. General Observations Purposes of a Limited Partnership

o Limited partners are only responsible up to extent of their investments and don’t have full control of management. There must be a general partner with unlimited liability, though the general partner

can be a corporation, which has inherently limited liability o Tax purposes – provides additional planning flexibility and similar tax benefits without

general partnership liability LPs were attractive tax shelters for a while – set up LP, generate losses for

accounting and tax purposes to offset against income of the partners – IRS closed this loophole

Limited Partnership Trade-Off:o Original Concept – small organization with a few limited partners, all of whom wee

passive investors Limited partners didn’t vote, didn’t act as executives, didn’t really participate. If they

became more active became general partners w/ general liability o Give up actual control and participation to immunize against debts and actions of the

partnership. Liable only to the extent of participation, contributiono Similar to the limited liability of corporate shareholders – EXCEPT that they can

participate without incurring risk of liability Even when active, no personal liability So why maintain the difference? LPs have typical partnership benefits, after 1976 the

restraints on participation have been relaxed Limited liability corporations are the modified version coming form the other

direction – allows both incorporation and partnership-like taxation LP’s MUST file with the state Department of State or Commerce. Can NOT have a limited

partnership by default without filing. Filing certificate must include:o Name of limited partnershipo Address of officeo Name & address of general partnerso Name & address of agent for service of processo Latest date at which LP will dissolve – though it might be indefiniteo Any other matters the GPs want to include – but they won’t include anything else, limit

disclosure to only the minimum requiredo This is NOT the partnership agreement – that doesn’t have to be publicly filedo What happens if the certificate isn’t filed?

Old law – if no filing of the LP certificate, the partnership fell into the residuary category of general partnership (which can be implied through conduct) But that’s very harsh, imposes general liability on people who thought they were

only limited partners New law – unlimitedly liable, but there are ways to mitigate, get out of it, §304

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Lesson – Make sure you’re a limited partner up front, before investing. Check the status, get confirmation of good standing from partnership, personally look for filing certificate

2. Revised Uniform Limited Partnership Act (RULPA) – LPs are statutorily based §102. Requirements for name of partnership: words “limited partnership”, may not list

limited partners or have certain words. §201. Requirements for certificate of limited partnership – MUST execute and file a LP

certificateo Consequences – because documents are filed, under FOIA you may be able to get lists of

existing limited partnerships §206. Requirements for filing certificate. §303. Conditions of limited partner’s liability to third parties.

o Allowing LP to participate a bit more and avoid general liabilityo §303(b) – enumerating actions that do not, on their own, transform limited partner into

general partner: LP does not participate in the control of the business solely by doing one or more of the following (hard to really understand…) Being a contractor or agent Being an advisor Acting as a surety Pursuing a derivative action Requesting a partnership meeting Proposing, approving, disapproving certain matters…List of important actions

o They get a lot of power, without becoming general partnerso Purpose – modernize the ULPA, reverse Holzman, let LPs be more than passive investors

Limit power of GPs over rights/interests of LPs, empowers the investors and allows them to be more active in conduct of partnership w/o exposure to liability

o Effect – has really encouraged resurgence of use of limited partnership §304. Avoiding accidental general liability

o People who erroneously (in good faith) believe they are limited partners of a general partnership shall be treated as limited partners.

o Mitigating harshness of failure to file or a faulty filingo Fix the defective filing, file the appropriate certificateo May still be liable for detrimental reliance by 3rd parties before filing o Problems – both cures are difficult to implement, it’s hard for a limited partner to get the

general partners to do this stuff…o Can always withdraw and forfeit interesto Want to keep some of the harshness of the rule because defective filing can indicate

fraud, a partnership acting w/o legal counsel, etc… Note that LP acts have been revised to allow some role for limited partners in management.

3. Holzman v. De Escamilla (Cal 2d) (1948) – Limited Partnerships Limited partners Russell and Andrews told general partner de Escamilla what crops to plant

and had unlimited access to the partnership’s bank accounts Were they limited partners or liable as general partners? General because they exercised

sufficient control over day to day operations, were acting as GPs.o A partner can be considered a general partner in an LP if:

Name is on certificate Represents himself as liable Takes part in management

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In this case, the “limited partners” were clearly involved in the management and thus should be treated as general partners. They could overrule general partner’s choice of crops to plant and had a direct role in finances.

This is no longer the case: RULPA § 303(a) added to avoid the Holzman holding: o Some participation of limited partners is now allowed without becoming a GP or

generally liableo The most important change from the ULPA was the addition of a safe harbor of

participation by limited partners that is not deemed “control” sufficient to make them liable as general partners.

o LP is not liable unless 1) he is also a GP; or 2) participates in control of the business, but there is a safe harbor. If LP participates in control, he is liable only to 3rd parties who transact with the LP reasonably believing, based on LP’s conduct, that the limited partner is a general partner.

LAW OF CORPORATIONS

XIV. Nature of the Corporation: Establishment and Limited Liability

1. General Observations History: Corporations originally chartered by the British Crown, then under special

corporation acts in the U.S. Current law - Now there are general corporation acts for each state.

o Most states have not adopted a uniform corporate code, with general incorporation acts RMBCA NOT substantially followed in NY, CA, Del.

o State system – Corps will incorporate in either state w/ main headquarters or state that has attractive laws States still retain power to grant/allow corporate status, but it’s much easier to

incorporate now Some states have subheadings for ‘closely held’ corporations, but these are really the

same form as public corporations. State competition for incorporation – lower the regulatory thresholds make

incorporation in a state more attractive. Offer a combination of certainty, clarity, responsiveness, speed in the corporate legal system. State benefits indirectly – spinoff industries, corporate headquarters, filing fees Delaware clearly won - expert court for corporate jurisdiction, procedures and

practices that are also more favorable, offers quick resolutions State law of state of incorporation will generally govern the internal affairs of a corp

– determines choice of law, conflict of laws results Comity between corporations

Corporations incorporated in one state, but doing business in another state is considered a foreign corporation, governed by foreign corporation provisions – generally entitled to full faith and credit for corporate acts

Corporations have to file in each state that they’re going to be doing business in, subject themselves to jurisdiction in those states

For tax purposes, state taxes are calculated based on application of a formula to where you do what (percentage of) businesso Allocate income to the proportion of business done within the state, relying

on a certain number of factors – fixed assets in the state, proportion of payroll paid, sales made within the state

International corporations are covered by alien corporation provisions

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o Not always entitled to full faith and credit so many companies will establish a US incorporated subsidiary to get better legal protection

o US incorporation is a much easier process than in other countrieso Some federal contributions – corporate law that affects interstate commerce can be

covered by federal law Particular focus on the interstate trading of corporate securities Recently increasing component of corporations law – still small federal piece

though… Corporations establish a limited liability regime - All participants have limited liability even

if they participate in management. Key element to the “corporateness”o But what do we mean by limited liability? Are there limits to the limited liability

concept? o Why is limitation of liability appropriate or necessary?

Necessary to raise capital in the marketplace Limitation on the risk of investing corporate capital – investors wouldn’t want to

invest if everything they own is at risk So it is seen as producing a better capital raising structure – probably true

Good general concept, though potentially difficult to apply in complex situations – how does liability get passed through, limited in multi-tier corps

How to create a corporation?o Deliver articles of incorporation to sec of state for filing – need to file the document of

incorporation Containing: corporate name, number of shares corp is authorized to issue, street

address of registered office/agent, name of officers (really?)o Arts. of inc. are extremely important – need to be drafted carefully, like the partnership

agreement Although it is often easier to draft articles of incorporation for a large public

company than for a small, closely-held company2. Revised Model Business Corporations Act (RMBCA)

§1.23. Timing of document. Document accepted for filing is effective [i.e., considered filed] at the date and time of filing, or as specified in the document as its effective time on the date it is filed.

§1.25. Filing duty of Secretary of State is merely ‘ministerial’ – i.e., doesn’t affect the validity of the document, relate to correctness of information in document, or create a presumption that the document is valid or invalid. Just a prudential requirement.o State needs to accept the filing as long as it’s filled out correctly, there are no naming

conflicts, and the fee’s been paido Though state can challenge the incorporation

§§2.01-04. Incorporationo §2.02. Sets out requirements for articles of incorporation: corporate name, number of

share, address of office and name of agent, name and address of each incorporator. o §2.03. Timing of incorporation (the same as timing of document) – unless a delayed

effective date is specified, corp comes into existence when articles are filed So filed articles are conclusive proof that corp has been established, unless state

challenges the filingo Reservation of power provision what section - Legislature is allowed to change the

corporate law, can apply changes to existing corps as well as going forwards State can always change the law and make it stick Response to Dartmouth College case – changes to corporate law challenged as ex

post facto property deprivation

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Reservation provision eliminates the challengeo §2.04. Liability for pre-incorporation transactions.

All persons purporting to act as or on behalf of a corporation, knowing there was no incorporation under the act, are jointly and severally liable for all debts created while acting

If you don’t properly establish the corp liable as some sort of residual business association, courts will imply partnership

Problems with imputing liability here: What if the parties don’t know that there is no corporation? What does jointly/severally liable mean? Partners are liable as partners, not

individually liable until the partnership capital is exhausted Most courts now look behind the formalities of this, confirm that there’s actually

some active business association before imposing liability §§3.01-04. Purposes and Powers of the Corporation.

o §3.02. Note that this includes general power to make charitable donations. Also includes power to make political contributions.

o §3.04. “Ultra Vires” – A corporation’s power to act can only be challenged in a proceeding by a shareholder to enjoin it from acting, by a receiver, or by the Attorney General.

3. Entity status of the corporation – doest it exist as an entity? What happens it if wasn’t properly put together? Are there liabilities? Classic, easy category of cases – those in which A, B, and C try to form a corporation but it

isn’t a corporation. Doing business as a corp but never actually incorporated apply doctrine of de facto incorporationo Wasn’t a corporation but acted as one, so P should be barred from bringing an action

against the individualso But this is a game of rules, not representations – act like a corporation, get treated like

one Another easy case - P brings action against the entity as a corporation, the corporation has

money, but the individuals try to claim no corporation to protect the assetso P can sue the entity, and the individuals will be estopped from denying the entity

Rule - If corp is defectively incorporated, P can get to the entity’s assets as well as the individual’s assets

4. Southern-Gulf Marine v. Camcraft (La.App.1982) – Corporate Entity Status, Corporate Existence Defendant promised to construct a large boat for plaintiff. It turned out that their contract

was signed before the plaintiff had incorporated. Camcraft tries to get out of contract with Southern-Gulf by arguing that contract was invalid because Southern-Gulf wasn’t incorporated at the time of the contract

Is Camcraft prevented from denying S-G’s corporate existence? YES. Camcraft is bound to contract, S-G sufficiently exists as a corporationo S-G execs acknowledged it to be a corp and treated it as such and has incurred

obligations that are now sought to be enforcedo Absent harm to the substantial rights of the defendant arising from the plaintiff’s lack of

incorporation at the time of the contract, the contract should be enforced. Fits better with the underlying equities

o “We believe the defendant, having given its promise to construct the vessel, should not be permitted to escape performance by raising an issue as to the character of the organization to which it is obligated, unless its substantial rights might thereby be affected.”

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Generally, court will construe the transaction as the intention of both parties to form a binding contract. Doesn’t matter at what stage the corporation was formed – they’re boundo Affirming the contract after the corporation is formed: the principal corporation can

affirm the contract entered into by the agent promoter, making it binding on the corporation even if the corporation didn’t exist at the time the contract was created. Just forming the corporation isn’t enough – the corporation needs to act to affirm the contract.

o “Where a party has contracted with a corporation, and is sued upon the contract, neither is permitted to deny the existence, or the legal validity of such corporation.”

Lesson: You really should incorporate first, rather than entering into preincorporation contracts – they are a bad practice today, especially since incorporation is so easy. o To form a corporation, all you need to do is file. Failure to file leaves you with a GP, and

all involved are jointly and severally liable. Corporations exist under state law, usually DE or the state where corporation is located.

5. Piercing the Corporate Veil – To what extent are corporate borders going to be respected? Do we go behind the corporate form? When? Typical situations:

o Shareholder/parent corporation does business with P directly (McDonald’s) – the fact that there is a corporation in between doesn’t matter

o The corporation is a mere shell: no meetings, no bank accounts, no assets, no books, no employees, etc

o Capital assets are inadequate to cover liability – if there is a fraudulent scheme, grossly inadequate capitalization, knowledgeably using corporate entity as a structure to avoid liability CA courts more willing to pierce because of manifest under-capitalization than NY… Problem - What if a corporation is sufficiently capitalized and insured, but the nature

of the liability risks are just too large? Can you then go through to parent corp or individuals?

2 forms of injury – tort and contracto Contract – less likely to pierce the veil

Plaintiff has entered into a voluntary, presumably eyes-open relationship with corp, should understand that corp has only limited liability

Plaintiff made the deal, should be held to that deal, shouldn’t be able to get behind it unless there are really pressing reasons

o Tort – more likely to pierce the veil, there are victims in a different sense Typical situations – products liability, accident compensation Injured parties didn’t have the same voluntary, risk relationship w/ the corp It’s less equitable to prevent recovery here when plaintiff didn’t know injury would

be sustained by a limited liability actoro Why do this? Real grounds for holding parent companies liable for subsidiaries:

Economic grounds – if P is benefiting from network element, may be better able to build into corporate structure protection for actions of S Identification created by the parent, inadequate financing of the subsidiary

liability for the parent Isolation and independence of the subsidiary, financial sufficiency no liability

for the parent Moral, social, equitable grounds – courts will get around insulation of subsidiaries to

protect the parent company by using estoppel, representation arguments More of an agency reasoning than corporate veil reasoning “The law permits the incorporation of a business for the very purpose of enabling

its proprietors to escape personal liability … but, manifestly, the privilege is not

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without its limits. Broadly speaking, the courts will disregard the corporate form … to prevent fraud or to achieve equity.”

Piercing the veil in a complex corporate structure – going behind the first veil to get to another corporation is more complicatedo Issues – where do the liability limits get drawno Why wouldn’t we? Want to protect upper corporate levels from lower level liability,

don’t want to disincentivize certain risks, innovations, want subsidiaries to take the risks, don’t want to force financial isolation from parent companies out of threats of liability Corps should be able to structure their affairs to take advantage (to some hopefully

good faith degree) of the benefits of limited liability, can’t totally manipulate the corporate forms but should benefit

6. Walkovszky v. Carlton (N.Y.1966) – Corporate entity and limited liability, veil Carlton owns a collection of tiny taxicab corporations so as to limit the exposure of each.

Plaintiff wanted to collect from Carlton because primary company asset was the taxi medallion which was judgment proof.

Could plaintiff pierce the corporate veil to hold Carlton individually liable for accident damages? NO.o “Broadly speaking, the courts will disregard the corporate form whenever necessary to

prevent fraud or to achieve equity.”o “It is one thing to assert that a corporation is a fragment of a larger corporate combine

which actually conducts the business … It is quite another to claim that the corporation is a “dummy” for its individual stockholders who are in reality carrying on corporate ends … Either circumstance would justify treating the corporation as an agent and piercing the corporate veil to reach the principal but a different result would follow in each case. In the first, only a larger corporate entity would be held financially responsible … while in the other the stockholder would be personally liable … Either the stockholder is conducting the business in his individual capacity or he is not.”

o It’s not fraudulent to carry on the business through multiple entities even though it could also be legitimately carried on as one corp Also not fraud since each corp met the minimum operating, insurance requirements

o Individuals are liable only if they’re carrying on the business in a personal/individual capacity

Problem – holding is a denial of reality in some sense, the corps were broken up artificially to limit liability o Is it appropriate/equitable to fracture the corporate structure just to limit liability?o NY is on the most respectful side of the spectrum, other courts will be more realistic and

less tied to the formalities of corporate divisions Note: P could have advanced a theory of enterprise liability: P should have sued all the cab

companies, not just Carlton and the cab company that hit him. That wouldn’t have lifted the veil, but you could have tried to prove that all the little companies were really one big company and then hold the larger corporate entity liable.

7. Sea-Land Services, Inc. v. Pepper Source (7 th Cir. 1991) – Reverse Piercing, Corp as mere instrumentality, unity of interest Sea-Land shipped goods on behalf of Pepper Source and then was stiffed on its freight bill.

The owner of Pepper Source also owned four other business entities which conducted substantially the same work. Sea-Land sought to hold both the owner and his other companies liable.

Can the corporate entity be disregarded, can the veil be pierced to hold the other companies/individuals liable? YES.

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o A corporate entity will be disregarded when two requirements are met: Both were clearly met here… Such unity of interest and ownership that the separate personalities of corp. and

owner no longer exist. – in effect, corp isn’t doing business, the shareholder/owner is Four factor test for determining unity of ownership:

o Failure to maintain adequate corporate records and formalities – signals that corp has never really been activated

o Commingling of funds or assetso Undercapitalization – grossly inadequate capitalo One corporation treating the assets of another as its own

Adherence to fiction of separate corporate existence would sanction a fraud or promote injustice. Standard of “promoting injustice” looser than affirmative fraud.

Van Dorn Piercing the Corporate Veil Test: here was such a unity of interest and ownership that the separate personalities of the corporation and the individual (or other corporation) no longer exist and the adherence to the fiction of separate corporate existence would sanction a fraud or promote injustice. Promote injustice means something more than just an unsatisfied judgment – there must be some “wrong” beyond a creditor’s inability to collect.

o The corp form was a mere instrumentality – for all intents and purposes, the corporate actor is the shareholder

Siegel : It is very rare for P to obtain recovery from a shareholder when the corporation can’t pay, especially in a contract case. Less rare in a tort case.

8. Kinney Shoe Corporation v. Polan (4 th Cir. 1991) – Piercing the veil, absence of corporate formalities Defendant created two corporations: first was an industrial company and second held a lease

to a building, which it then subleased to the first. Second had nothing but the sublease, no assets, income, bank account. Plaintiff was the landlord who had leased the building to the second company. When second corporation did not pay its lease, the plaintiff wanted to go after the first corporation and its owner.

Could P pierce corporate veil to hold Polan personally liable to money owed on lease? YES.o Grossly inadequate capitalization combined with disregard of corporate formalities,

causing basic unfairness, are sufficient to pierce the corporate veil in order to hold the shareholder(s) actively participating in the operation of the business personally liable for a breach of contract to the party who entered into the contract with the corporation.

o Court added an option third prong to the two-prong test in Pepper Source: if the plaintiff should have known that the corporation was grossly undercapitalized, it should not be able to pierce the corporate veil.

o 3-prong test: 1) unity of interest and ownership such that the separate personalities of corporation and shareholder no longer exist; 2) an equitable result would not occur if the acts are treated as those of the corporation alone; 3) it would not have been reasonable for that type of 3rd party, entering into contract with corporation, to conduct an investigation of the credit of the corporation (i.e. 3rd party did not assume the risk). Court rules that application of the 3rd prong is optional and does not employ it here because it would not lead to the equitable result. Check that.

9. In re Silicone Gel Breast Implants Product Liability Litigation (N.D.Ala.1995) – Piercing the veil in a tort case Bristol-Myers Squibb is the sole shareholder of Medical Engineering Corp., a subsidiary

company that manufactures and distributes breast implants.

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Could MEC’s corporate form be piereced to sue BMS for products liability? YES. MEC is so controlled as to be the alter ego or mere instrumentality of its stockholder, Bristol, and, because of MEC’s inadequate capitalization, it is in the interests of justice to disregard the corporate formo Used two-prong test. Injustice prong handled by fact of the tort. Unity prong is focus of

the case.o Factors in whether a parent should have liability for the torts of a subsidiary:

Whether P and S have common directors or officers Mixing of P & S’s business departments and shared finances Whether the S is grossly inadequately capitalized Whether P pays S’s salaries and expenses – big trigger if S doesn’t have its own

payroll Whether P uses S’s property as its own Whether P caused incorporation of S Generation of business – whether S receives business other than that given to it by P Mixing of daily operations Whether S does or does not observe basic corporate formalities - keeping separate

books and records and holding shareholder and board meetings (this is the killer if you find it, which is unlikely)

Fraud or representational issues – is P representing itself as in control Note that Delaware courts do not require a showing of fraud or injustice if the corporation is

just an instrumentality of its sole shareholder. Underlying issues – whether corps will be liable for mass torts that result from actions of

their subsidiarieso Akin to Berkey v. Third Ave Ry Co – a favorite of Siegel’s

10. Frigidaire Sales Corporation v. Union Properties, Inc. (Wash.2d 1977) Frigidaire tries to hold limited partners of LP liable as GPs because they are the officers,

directors, and shareholders of the corporation GP. o Tax Shelter Issue - Tax shelters take advantage of the fact that due to some accounting

rules (e.g., depreciation) a firm can appear to lose money even if it is economically profitable. Standard form for a tax shelter, especially in mineral extraction and real estate industries, is a limited partnership with a corporate general partner.

Could the veil be pierced to hold LPs liable? NO. That’s not the kind of “control” that RULPA was envisioning and all defendants adhered to the formalities of both partnership and corporate lawo RULPA allows a corporation to be the GP of a LP. As long as you follow the formalities,

there is no issue; you will not be held liable.o Corporation was the actor here, not the individual partners – Can’t blur the line between

corp and people acting on behalf of the corp, one key element of “corporateness” i.e. if a person signs a contract for a corp, person isn’t liable, the corp is…

o Corporate form is a shield unless being used just to avoid liability – if there is abuse of the corporate form, the veil can be pierced.

Lesson: A 3rd party transacting with a corporation should do the following to protect itself: 1) get insurance coverage so you don’t need $$ from corporation; 2) demand disclosure of financial information so that you can make sure it is adequately capitalized; 3) insist upon an auditor; 4) ask parent to make a guarantee for subsidiary; 5) walk away if they don’t give you the assurances you want.

XV. Shareholder Derivative Actions

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1. General Observations Shareholder actions to compel a corporation to sue: Under defined circumstances,

shareholders may in effect initate an action on behalf of the corporation. o Outsiders (shareholders, employees, customers, community members) with an interest in

how the corporation operates either try to get the corp to act or act themselves on the corp’s behalf Conception of shareholders as outsiders – there is a shareholders meeting and they

can vote on major corporate changes, but they basically elect the board of directors and delegate all management power to the board

o Suits usually brought against corporate ‘insiders’ – challenge what the board has done with the delegated powers. Problem – American law strongly favors the corporation, great deference to corp

board and their business judgments Encourage shareholders to vote in a new board rather than litigate Need to balance shareholders’ right to force a corp into lawsuit when appropriate

but restrain free, costly second guessing of the board through litigationo The shareholder is nominal plaintiff and corporation is nominal defendant (because

shareholders suing corporation, but to get it to sue someone), but corporation is real plaintiff in interest (SH ex rel Corp v. Director/3rd party) Why would shareholders exercise this option

Board knows D and chooses not to sue Board itself breaches duty of loyalty or duty of care to corp

Ultimate purpose – benefit the corporationo Remedy flows to the corp – indirectly benefits shareholders by increasing value of shareso Only personal benefit is for the attorney

Controlling standards – Business Judgment Rule, Equitieso Shortcut way courts have used to describe the fairly low standard of care that directors

are to be held to in evaluating their activitieso Used as a way of testing ex post whether a decision or act of the board of directors

satisfied their obligation of care or did not satisfy the obligation, and whether it gives rise to charges of personal liability

o Problem - a bit of ambiguity in the way the rule is discussed Some elements relate to the duty of loyalty 2 standards applied to fiduciaries – loyalty is one

Negative – agent/fiduciary is forbidden to compete or act in a negative way with respect to the principal, directors are under the same obligation

Affirmative – agent has to account over to the fiduciary all profits or benefits accrued because of the position, directors also under same obligation

Business judgment concerns the other standard – duty of careo The derivative action is one of equity, since the shareholder had no standing at law

Different states take different approaches – i.e. Delaware is surprisingly pro-shareholder despite being a very corporate-friendly state, NY gives a lot more deference to the board of directors.

2. Process of Filing a Derivative Action - Diagram

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3. RMBCA §§7.40-7.46. Rules governing derivative proceedings.

o §7.41(2). Requires that plaintiff must fairly and adequately represent the interests of the corporation, rather than shareholders similarly situation, as required in Federal Rule of Civil Procedure 23.1.

o §7.42. The RMBCA has a universal demand requirement (see discussion in Marx)o §7.43. Court may stay proceedings to allow investigation by independent committee.o §7.44. Allows independent directors, independent committee, or a court-appointed

independent panel to dismiss claims after a good faith investigationo §7.45. Does not require court’s approval for settlemento §7.46. Gives court leeway to order parties to pay legal expenses.

4. Delaware General Corporation Law (Del.) §327. This is a very short provision simply requiring that a plaintiff was a shareholder at the

time of the transaction in question. Presumably the details are handled through common law precedents.

5. New York Business Corporation Law (NY) §§626-27. – Codifies the common law tradition allowing shareholders to bring suit

o In general, where the potential defendant is one or more members of the board or an officer of the corporation, and a shareholder is trying to hold them accountable for violations of fiduciary obligations or duties of care, an action may be brought in the right of a domestic or foreign corporation (although choice of law answered by the state of incorporation)

o Requirements Contemporary and contemporaneous ownership requirements – P must prove that he

is a current shareholder or was a shareholder at the time the issue aroseo §626(c). Demand on the board requirement - “In any such action, the complaint shall set

forth with particularity the efforts of the plaintiff to secure the actions of the board or the reasons why the efforts weren’t made” Requires an account of what shareholders did before coming to court or why they

didn’t do anything. Purpose – give the corporation a chance to deal with the problem internally before

initiating a large-scale litigation. Might be more efficient to allow the corporate board to deal with things on their own, but in reality, how likely is it that the corp will take the case?

o §626(d). Requires court supervision of settlements.

Is Demand Required?

No Excuse. Demand Required. Excuse. No Demand Required

Board approves proceedings. Case proceeds, supervised by court Decision on the MeritsBoard does not approve Proceedings

Court determines that plaintiff will not have opportunity to get hearing Court determines that Board was interested

Hearing on the merits

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Court can maintain action under a discretionary authority Court can prevent an action from being compromised or settled in a way that does

damage to the corp or doesn’t benefit the shareholders, prevent strike suits and other manipulations of the litigation options

Cuts out the ability to split the settlement between the attorney and just one shareholder

o §626(e). Allows plaintiff to recover legal expenses through judgment, but must turn over all other awards to corporation. Costs and rewards may be charged to the corp Siegel : legal fees are not the only motivating factor behind major shareholder suits,

and even if suits are profit-oriented, it’s better to at least have someone challenge the problems

o §627. Security for Expenses - Requires posting a bond for small shareholders (5% rule). Unless P holds 5%, or the interest has a fair value in excess of 50,000, the corp shall

be entitled at any stage of proceedings before final judgment to require P to give reasonable security for expenses, including attorney fees, which may be incurred by it in such action and by the other party’s defendant incurred in the action

Substantively, court has power to force P to pay the litigation expenses out of the security bond

Major change in normal presumption that each party pays its own legal costs – a way to restrain the overuse of the derivative option

Evaluated in Cohen v. Beneficial - is this constitutional? Is it just procedural or also substantive? Is it appropriate to deal with the abuses perceived before the provision? Within the commerce power of the states? Yes to all… and it is a substantive provision

o Taken together, these provisions really prevent shareholders from taking advantage of the corp through a derivative suit. Cut off option for personal suits and quiet personalized settlements…

6. Cohen v. Beneficial Industrial Loan Corp. (U.S.1949) – Introduction to Derivative Suits Beneficial, a DE corporation d/b in NJ, wants shareholder bringing derivative action in NJ

fed dist ct against officers to post security for expenses under NJ statute. Is the security provision constitutional? Is it substantive or procedural?

o Court goes into history of “strike suits” or nuisance lawsuits designed to result in settlements primarily benefiting plaintiff’s lawyers. Having a share threshold (i.e., requiring 50,000 shares) is not an unconstitutional way of screening strike suits.

o Substance v. Procedure matters for Erie questionso Concluded that federal court with diversity jurisdiction must apply a state statute

providing security for costs if the state court would require the security in similar circumstances

Siegel : Cohen today might have gone the other way, depending on the Supreme Court’s level of activism regarding state laws.

Siegel : problem with this is that it may decrease the numbers of both good and bad law suits and reduces the control of minor shareholders. However, with inflation, $50,000 is becoming less and less of a barrier. Security-for-expense statutes no longer exist in most jurisdictions, although one still exists in NY

7. Eisenberg v. Flying Tiger Line, Inc. (2 nd Cir. 1971) – Derivative or Direct Suit? Note flow charts below:

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XVI.

Because of restructuring, minority shareholders in parent don’t have a vote in the subsidiary. Majority shareholders claimed the move was for tax and regulatory reasons. Eisenberg brings a claim in NY court to enjoin a merger, and DE corporation Flying Tiger wants him to post security per NY § 627

Does §627 apply? Really a question of whether this is a derivative suit (requires the bond) or a direct action (doesn’t)o Since alleged harm was to Eisenberg himself (i.e., his rights as a shareholder) and not to

the corporation, the suit was direct and not derivative.o Need to distinguish actions that are brought by P for corp against D from actions brought

by P as an individual against the corporation itself Depends on the nature of the remedy – does it flow to the corporation or to the

shareholders? Here trying to enjoin the company, directly affect the corp

Siegel : Eisenberg is correctly decided on the characterization of the suit, but substantively Eisenberg doesn’t have a claim – today, a shareholder’s disclosure right is protected, but not his right to intervene. Also, the result in this case would have been different if Eisenberg had claimed that the directors had violated their duty in approving the merger – then the claim would have been against 3rd parties alleging a harm to the corporation.

Note that in both Cohen and Eisenberg, below, a Delaware corporation is sued under the laws of another state. Thus, the internal affairs doctrine has limitations.

In a direct suit, the essence of the claim is that the individual is injured, not the corporation. (Make sure this is right…)o Recovery of benefits, return of assets, recovery of excess salary – remedy would flow

from 3rd party to the corporation Corporation is beneficiary of recovery – derivative suit Shareholders benefit indirectly by corporation benefiting directly

o Classic direct suit – Dodge v. Ford Shareholders of corporation demand that they be paid a dividend Remedy flows from corporation to the third party Direct action in sense that corporation is the real defendant, directly subject to the

remedy2. Gordon v. Elliman Was this used in Eisenberg???

NY case confused the whole thing because the remedy was nonmonetary, universally recognized as the wrong decision…o If relief is monetary: cash to corp derivative, cash to shareholders directo If relief is nonmonetarh: action/injunction against corp direct

3. Demand On The Directors: One of the core requirements for a derivative suit

FT

FTC

FTL

FTC

FTL

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Originally, FT was the only company. It created a subsidiary FTC, which in turn created another subsidiary FTL.

FT then merged into FTL, and shares of FT were converted into shares of FTC. FTL became the operating company and FTC the holding company.

Thus, minority shareholders in the former FT were now shareholders in the holding company, but had no power over the operating company.

Lots of case law on demand excusals, but much less concerning what happens if Board rejects a demand. Law isn’t settled.

Generally, the only way court will intervene after rejection of demand is if plaintiff can show that defendant’s decision-making procedures were not followed.

Under all laws, if plaintiff makes a demand, he cannot afterwards seek excuse.4. Grimes v. Donald (Del.Sup.Ct.1996) – Del. Demand Case

Golden parachute case: Grimes alleges that the directors breached their fiduciary duties by abdicating their authority, failing to exercise due care, and committing waste, when they signed a long term contract with Donald which delegated to him all managerial functions and that provided that if they fired him, they would have to pay him off.o There were two possible sets of claims: abdication of power by Board (a direct claim)

and lack of due care, waste, etc. (derivative claim). o Note: it’s now unlikely that courts will examine compensation amounts if execs can

provide evidence of similar salaries at other corps Real issue – did the board abdicate its responsibilities by providing that Donald’s

management of the corp couldn’t be interfered with? NO. Board is still in charge b/c could still fire him.o Court sees it as a 2 part claim –

1) that the contract represented an abdication of the board’s responsibility, by eliminating power to supervise. P trying to remove that contract provision. Court saw it as a direct claim, not requiring advance demand on the board or

other requirements of a derivative suit 2) Claim to recover excess salary

Viewed as derivative – claim made against the board, flowing against a 3rd party back to the corporation subject to all derivative suit requirements, including demand

The derivative claim raises the question of “demand.” Demand requirement is intended to reflect the fundamental priority of the Board in management of the corporation. o To excuse making a demand on the directors, you must argue that the directors are

interested in the transaction or that they are incapable of making an impartial decision. Delaware law says demand requirement can be excused if plaintiff shows:

o Majority of the board has a material financial or familial interesto There is reasonable doubt that majority of the board is capable of acting

independently/objectively (because of domination or control)o Reasonable doubt that underlying transaction is the product of a valid exercise of

business judgment o DE analysis of when a suit can go forward after demand has been refused: 1) is the

board so structured that they are capable of exercising business judgment?; 2) are the procedures that the board undertook to examine the desirability of the suit, on their face, sufficient to justify deference to the board?

If demand is rejected by the Board, Board is given presumption of business judgment rule. Plaintiff must make particularized claims that raise a reasonable doubt that the Board should be allowed this presumption. o Stockholder may have a remedy for wrongful refusal or may submit further demands

which aren’t repetitious, but can’t then ask for demand excusalo A plaintiff cannot both make demand and ask for excuse – one or the other only.

Implications for the Delaware setting – o If the issue is whether demand is excused or not, you’re going inevitably to prejudice the

case by making the demand

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o Once the decision gets to the board, their decision is examined rather than the substantive options for excusing demand, and it’s protected by bus judgment

o There are also high standards for granting excusal of demand – need real proof about the board’s inability to make the decision impartially

o Esp w/ independent litigation committee eliminates argument that the corporation can’t make the decision itself demand is required and P will then have to prove that rejection of demand was inappropriate

5. Marx v. Akers (N.Y.1996) – NY Demand Case Action brought charging that outside directors’ pay was excessive. Shareholder didn’t make

demand, claimed that demand would have been futile. Was demand required? YES. P does not get demand excusal on the exec compensation claim.

Would have gotten excusal on the board compensation claim, but that action failed to state a valid claim b/c compensation was not excessive on its face so there was no injury to the corporation (highlights 2 parts of a derivative suit, procedural thresholds and then substantive thresholds) o According to NY courts, the purposes of requiring demand are:

Relieve courts from deciding matters of internal governance unnecessarily Provide Boards with reasonable protection from harassment by litigation on matters

clearly within the discretion of directors Discourage ‘strike suits’ commenced by shareholders for personal gain, rather than

for the benefit of the corporationo New York law says a demand can be excused if:

Majority of directors are interested in transaction Directors fail to inform themselves to a reasonable degree about transaction (not

explicitly in Grimes) Directors failed to exercise business judgment in approving transaction (transaction is

egregious on its face) Some states (not NY) have a ‘universal demand requirement’ that cuts out excuse altogether. Siegel : We don’t spend time on compensation anymore, because courts allow the market to

set reasonable prices. As for setting director compensation, of course they are interested. Most corporate statutes specifiy that in setting compensation for themselves or the executives, they’re not interested. Approval of salaries by shareholders in the US is unheard of.

6. Litigation Committees – Major strategy for skirting demand excusals, corp efforts to block derivative suits Under both New York and Delaware law, even outside members of the Board are often

interested in the outcome of a derivative suit because they could be found liable for a breach of their fiduciary responsibilities if the plaintiff prevails. Thus, the committee structure developed – because otherwise there would almost always be excuse.o Committee set up to avoid the interested-director justification for a demand excusalo Corporation delegates to such a committee the responsibility of examining the suit to

determine whether or not it should go forward And this is a proper delegation, not an abdication of the board’s responsibility

Terms of such delegationo Litigation committee is typically comprised of non-Board members, prove its

independence o Given tools to obtain necessary info to evaluate the claimo Determination of committee about proceeding w/ litigation is final, not reviewable by the

board o Answers al the possible objections to having the board make this decision itself

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No problem of member interest, no problem of lack of information Determinations are definitive

Problems – Even if impartial, how likely is it that such a committee will in fact determine that a litigation should proceed?o Would committee challenge corp culture and support a suit?

So courts may need to examine the lit committee decisions…o Is the litigation decision really something that should be controlled by a bus judg

standard? Not really a decision about a business transaction, different things at stake Evaluating a judgment about something that is NOT a business transaction, it’s a

decision about how to evaluate an underlying bus transaction – a few steps removed…

Court evaluations of Lit Committee Decisions: Assessing the actions of the committee, not the liability of the defendanto Look first to the committee’s independence – is the lit comm. Carrying out its obligations

w/o conflict of interest, acting independently? Must be independent for its determination to carry any weight Though can the committee ever be truly independent? Too beholden to corporate

structure/system, even if not to particular corp? Elements of independence – Are the committee members non-participating directors?

Fully independent committee of non-directors? Established before there was a threat of litigation? Independently financed? Decisions protected from review by board?

o Then look to the methodology and procedure of the committee? Courts can look at lit comm’s procedure, but can’t “trespass in the domain of

business judgment” – not did they make the right decision, but did they make it in the right way…

Nature of comm’s procedure – evidence, hearings, investigation, creation of a recordo In New York, litigation committees are only required to make a prima facie showing of

independence. Thus, New York tends to reserve business judgment to the corporation. Look at the decision on its face

o In Delaware, court looks more at details of committee’s decision-making process. Also looks at whether litigation committee’s decision corroborates the court’s independent judgment. Look at the decision on its face, then look again, let the court apply its own business

judgment7. Auerbach v. Bennett (N.Y.1979) – New York Litigation Committee Case

Litigation Committee ‘investigates’ cases of corporate bribery and finds no reason for filing a claim.

Was the lit committee’s decision valid, should it be followed? YES. Not evaluating the fiduciary responsibilities of the board itself, but whether the lit committee has met its own fiduciary duties…o Court rules that it can investigate the independence of the Committee as an initial matter.

Examination of Committee has two components: Selection of procedures appropriate to the pursuit of its charge Substantive decision predicated on the procedures chosen. Decision itself falls

squarely within business judgment ruleo This committee was independent, followed proper procedures decision shielded by

bus judgment rule. (shorthand way to describe the low standard of care applied to directors in carrying out their duties)

Sets up 2 part NY Test

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o Is the committee independent? o Were the methodologies and procedures that the committee used to conduct an

investigation of facts and determine legal liability suited to that task? o Note that the court cannot look into the substantive decision of the committee itself

(business judgment), only the adequacy of the procedures followed. Siegel : Although Marx v. Ayers rule (demand is excused as futile if transaction so egregious

couldn’t have been product of business judgment) makes you wonder if NY wouldn’t look substantively at similarly egregious decision made by committee.

8. Zapata Corp. v. Maldonado (Del.1981) – Delaware approach to Litigation Committees When Maldonado instituted a derivative suit where demand would clearly be excused

because all directors were implicated, firm appointed two new outside directors to the board for an “independent investigation committee” composed solely of those two directors. Lit comm dismissed derivative claims on grounds that continuing suit would hurt the corp, inimical to corp’s best interests.o Action would have gone ahead but for lit comm

Was the committee’s decision valid? Can the committee terminate the suit? YES. When, if at all, should an authorized board committee be permitted to cause litigation, properly initiated by a derivative stockholder in his won right, to be dismissed?o Court rules that an independent committee should be able to file a motion to dismiss a

derivative action if: Court should inquire into the independence and good faith of the committee

(compression of NY test) Court should determine, applying its own independent business judgment, whether

the motion should be granted. (implicit decision on the merits) Not satisfied with easy acceptance of lit comm’s bus judgment

o DE test: looks into independence and procedures AND the Court should make its own business judgment whether the motion should be granted.

o Implications of these two views: P’s counsel has the choice of venue in derivative suits and complex transactions; NY and DE apply their own rules, even if the corporation is incorporated elsewhere.

Siegel : There is a philosophical difference on the distribution of powers between the corporation and the court. DE says the court has the last word. NY says the corporation does. SS likes the DE approach better. o Problem – how does the court have a business judgment? Implies that this isn’t really a

business judgment situation…

XVII. Corporate Purposes

1. General Observations Underlying issue – are corporate donations allowable as part of a corporation’s purpose? Yes. Today, even in the absence of a specific corporate benefit arising from a charitable donation,

there are almost no limits on what corporations can give.o Corporate giving is culturally bound: not in every country is a corporation expected to

give voluntarily to charitable causes. Note that while some statutes, such as Delaware §122, seem to merely authorize contributions

that further corporations’ business, courts are extremely tolerant of charitable gifts.2. RMBCA

§3.02(13). Allows corporation power to make donations for charitable purposes §3.02(15). Allows corporation power to make donations for purposes that further the

business of the corporation (e.g., political contributions).

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3. A.P. Smith Mfg. Co. v. Barlow (N.J. 1953) – Role and purposes of Corps. Analysis of corporate donation to Princeton. After A.P. Smith donates money to Princeton,

the stockholders complain that they weren’t authorized by the articles of incorporation and that the NJ corporate statute that allows corporate charitable giving doesn’t apply to A.P. because the statute was passed after its incorporation.o Defining the charitable corporation, requirements for corporate donationso Shareholders normally invest money for profit purposes, but if corp chooses to give away

money w/o evidence that it will increase value of corp or investments, is that appropriate? Are such donations allowable? YES.

o New statutes apply to existing corps. Legislature may alter corporate charter provisions in the public interest even if they affect the contractual rights between corporation and stockholders or stockholders inter se NJ reserved power to make changes to corp code, and to make amendments (here

providing for legitimate corp contributions) applicable to existing corpso Corp is authorized by statute in all jurisdictions to give money away as long as the

beneficiary is charitable or public interest in nature.o Policy justification for corporate giving is in part transfer of wealth to corporate hands

and heavy burdens of individual taxationo RMBCA § 3.02(13), 3.02(15): A corporation can give to other causes (political) as long

as it is legal and furthers the business and affairs of the corporationo General Rule – corps can donate, and if shareholders don’t agree they can pull their

investment In part a practical response - shareholders may not know, contributions may be below

the reporting threshold and may never be able to find out about it. Would be inequitable to allow them to pull out after.

4. Dodge v. Ford Motor Co. (Mich. 1919) – Corporate purposes and profits Ford avoids paying the Dodge brothers a dividend by paying employees more and lowering

prices – he pretends it’s for charitable purposes officially to put the mney back into the company, but really he’s trying to corner the market, push dodge’s out and then raise prices

Was Ford allowed to hold off paying of extra dividends, in part to expand its manufacturing capacity? NO. Ford had to pay dividends (one to the only cases to force this, limit a corp’s level of “charitable giving”). His plan didn’t go towards making a more profitable business. o Affirmed primacy of shareholder profits as the purpose for business corporations, but

says it should not interfere with long-term planning.o Can’t run a corporation for the benefit of others, need to protect profits and investments

Ford argued that not only does he not have to pay, but he had sound reasons for not doing so – was going to invest in infrastructure, help consumers

Effective rule - When a dividend is withheld for improper reasons, the court can mandate the payment of dividendso Contrary to normal rule – amount of dividends in absence of a contract provision to

contrary is in the absolute discretion of the boardo But where there’s a corp controlled by a small number of shareholders, it’s more likely

that the court will look into details of corp operation and if controlling shareholder is acting to harm minority holders may mandate relief.

o This remedy is almost always invoked in closely held, non-public corps when majority s’holder or board is acting in a way that’s oppressive to minority s’holders

Note that Ford was a pioneer in finance and the court probably didn’t pick up on all the factors involved.

Siegel : Can a corporation be run as a charitable organization? This implies no, but other cases are less clear.

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5. Shlensky v. Wrigley (Ill.App.2d 1968) Cubs owner refused to install lights in Wrigley field. Shareholders challenged decision on

grounds that installation was in company’s best interest, and decision reflected negligence and mismanagement by driving down profits

Can the court intervene and overrule this decision? NO. o court will not interfere with directors’ decision unless it at least borders on fraud,

illegality, or conflict of interest – otherwise, it falls within the business judgment of the board

o Interprets Dodge as requiring some fraud or breach of good faith o No evidence that corp was actually damaged extreme deference to boardo Effective rule – socially motivated charges or decisions can’t really be challenged as

business judgments (Ex. Dow Napalm case…) Presents planning problem - how to deal with a dominant majority s’holder:

o Include a forced buyout clause in the contracto Dispute resolution provisionso Insist on a public offering of stock so that there are buyers and there is no lock-in.

Note: Different approaches in different states…o In CA: Instead of looking at it as a matter of business judgment, they might look at it as

the dominant shareholder has a fiduciary duty to the other shareholders not to act as an oppressor – he’s driving down the value of their shares.

XVIII. Duty of Care

1. General Observations: Can directors be held liable for violating a standard of care? According to Siegel, this is not actually a “fiduciary duty” in spite of the RMBCA. [what is

it? A contractual duty?] Cases dealing with derivative actions that actually go to the merits, and the merits concern the

financial losses taken by the corp Underlying Issues:

o How and why do we hold directors actually liable for the corp results?o What is the standard of care applicable to directors and officers of a corp, and how are

they held to it?o What ways are there to limit liability – after Smith, directors seemed fairly exposed, but

we need to balance the interests in imposing liability with interests in limiting it… Statutory changes – like NY and Del did

But even with such protections, and even when director act reasonably, carefully and are still charged, they’ll incur 2 liabilitieso Costs of litigationo Personal costs – reputational damage

Indemnification/insurance option – good option if available, but doesn’t cover the personal consequences

Codes of corporate governance – more on the policy than monetary end, clarify the rules and make them as workable and open as a corp goes forward

Compensation agreements – make compensation of directors reflect risks, develop a monetary relationship between involvement of directors and risks associated Or reverse – don’t eliminate liability but cap potential damage awards in a way

that’s proportional to compensation for each director Reasons why standard of care applied to members of a corp’s board should be different from

standard of care applied to trustees, bankers, doctors, lawyers, etc?o Attempting to pin on directors day to day responsibility is potentially problematic

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o They are not normally conceived of running the operations themselves justifies a different standard of care, sense of responsibility, something that’s more distant

o They may have divided interests, different insights – if we want outside directors they may inherently have divided loyalties

o Impose less responsibility for directors who are merely supervisoryo Different corporate purposes – inherent risk taking more lenient standards

Business judgment rule – critical difference Different set of corporate assumptions – directors are supposed to take risks with

their investments, in order to make a larger corporate profit need to show more deference to that…

Can’t fault directors by imposing extremely strict standard of care would chill corporate risk taking

Can’t hold them liable for bad results or taking risks, only for not exercising care while doing so. Though extreme risk taking might violate standard of care itself

o Problem – if you insist in simplifying directors’ standard of care, you filter out important subtleties distinguishing risk and care…

Special obligations in certain circumstances:o In a takeover situation - once an outsider comes in, offers to buy the corporation and the

corporation then starts talking with other people to buy them out, the ground rules with respect to how the board acts begins to change Board doesn’t have an obligation to put corp on the market. But IF they are going to

sell the corporation, if they accept the idea of a sale but turn around to someone else to get another offer, and put the corporation in play, they have a fiduciary obligation to maximize the proceeds. (Smith v. Van Gorkom) If you’re going to sell the corporation, you have to do it at the highest price

o Once a corp is in play, there’s a duty to sell for the highest price, maximize value of the corp

General shifts in court approaches to this: Shifting pendulum…o Smith – moved towards holding directors liable

Planning – don’t act irrationally, or on an irrational time frame, act quickly to get full documentation not to make the full decision

o 102(b)(7) – moved back from holding directors liable, preventing liability Siegel : Eviscerating Smith… Planning – write a 102(b)(7) provision into the articles of incorporation, but really

follow it’s requirements, really keep information and do a full investigationo Disney – preventing the pendulum from moving too far back, reinstates a large degree of

Smith Court is just uncomfortable with saying that a corporation can act like this, regardless

of what the statute allows Tied into the general concern about the adequacy of corporate law – the courts, post-

Enron, etc, have had their confidence in corporate law shaken Planning – advise clients not to hire friends, or to really vet them, document the

decision if you do, make sure it’s a legit deliberation2. RMBCA

§8.30. Standards of Conduct for Directorso §8.30(b). Standard for oversight is the care that a person in a like position would

reasonably believe appropriate under similar circumstances.o §8.30(c). Board, unless it has knowledge that would make such reliance unwarranted is

entitled to rely on officers, experts, board committees.

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o Each member of the board shall act 1) in good faith; and 2) in a manner which the director reasonably believes to be in the best interests of the corporation (Kamin)

§8.31. The burden of proof is on the plaintiff: Director shall not be liable for any decision unless:o §8.31(a)(2). Decision is not in good faith; sustained failure of the director to devote

attention to ongoing oversight.o “with the care that a person in a like position would reasonably believe appropriate under

similar circumstances.” Presumption of non-liability, burden on P. A powerfully reduced standard of care … (Kamin)

§8.42. Standards for officers generally the same as for directors. Officers may immunize themselves from liability if they follow the duties listed in this section.

§2.02(b)(4), (5). Corporation may pass a bylaw eliminating or limiting the liability of a director except for (A) the amount of a financial benefit received by a director to which he is not entitled; (B) an intentional infliction of harm on corporation or shareholders; (C) making unlawful distributions; (D) violating criminal law.

3. Del. GCL §102(b)(7). The amendment to this apparently eliminates the standard of care requirement.

Even gross negligence (but not recklessness) can be protected from liability. Exceptions are for (A) breach of duty of loyalty; (B) acts or omissions not in good faith or intentional misconduct or knowing violation of law; (C) improper personal benefit.

4. NYBCL §620 – corporation can vest managerial power in some of the shareholders, but then they will

be subjected to fiduciary obligations and standards of careo Obligation not to commit breaches of good faith, to fully exercise business judgment, to

pay attention to affairs of corp, etco liability for managerial acts (if there will be liability) is not escapable if you’re in control,

regardless of your “position” §717. Direct shall perform duties as a director in good faith and with that degree of care

which an ordinarily prudent person in that position would use under like circumstances.o Not an overwhelmingly high standard of care – ordinarily prudent person in context,

specific to position of directoro Entitled to rely on officers, experts, committees – all basically in good faith.

5. Kamin v. American Express Company (NY 1976) – Obligations of control, duty of care Directors decide to distribute stock that had loss value in kind instead of selling it, foregoing

tax benefits but making their net earnings look better. Plaintiff challenged decision. Did directors breach duty of care? NO, business judgment rule protects even bad decisions if

made in good faith.o Interprets §720(a), which holds directors liable for negligence as meaning that they are

liable for negligence in their duties, not for mere misjudgment.o Directors did NOT overlook the facts called to their attention and attempted to view the

total picture in arriving at their decision. Countervailing considerations about loss recognition – not actually true but

reasonable assumptions for directors Effective rule: Courts won’t meddle in any seemingly-reasonable decision. Absent bad faith,

the fact that the decision was damaging to the corporation is NOT enough to invalidate ito Business is inherently fraught with risk, and we don’t want to discourage or needlessly

punish that. Court won’t interfere unless a clear case is made out for fraud, oppression, arbitrary action, or breach of trust.

Consequences – actions which seem pretty unreasonable, poor business decisions will still fall within scope of bus judgment rule’s protection

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o No cause of action for business courts of action that just doesn’t seem advantageous…o Need gross negligence, real failure to meet a reasonable standard of care to have a claim

6. Smith v. Van Gorkom (Del.Sup.Ct. 1985) – Duty of care Van Gorkom negotiated sale of Trans Union to Pritzker without really informing the board

about his decision or making or following protocol himself: just 20 minute presentation of planned sale at board meeting, copies of agreement were delivered too late for study, no presentation of any details, no seeking of any alternative offers.

Did the decision violate his duty of care? YES, the decision to approve the proposed merger was not the product of an informed business judgment and the Board failed to disclose all the material facts to the shareholders before securing their vote. Did the board discharge responsibilities adequately before signing on to the contract with the pritzkers? NO.o No procedural exercise of business judgment – at a minimum, the directors were grossly

negligent in approving the sale. Corp was in play, needed to sell for the highest price. That this was an above-market

price wasn’t enougho Failure of the Board to reach an informed business judgment is voidable, rather than void,

so can be cured by a proper shareholder vote. This vote wasn’t proper.o Siegel : Practical Considerations - Why would members of the board agree to this deal?

Top management picks the outside board members and then the shareholders accept them – if a member of a board asks a question, he’s out Decision more a product of corporate pressure than reasoned business judgment

Rules and Standards:o Court establishes ‘gross neglect’ as the appropriate standard for evaluating whether a

business judgment was ‘informed.’o Can’t transact w/ blindfolds on…

General Propositions:o When a board is engaged in making a decision re: complex transaction:o If the complex transaction does well or poorly for reasons inherent in the complexity

not a problemo BUT if the results are because of the way the decision was made, because board didn’t

pay attention to important details of the transaction, didn’t make the investment the right way violates the standard of care

Note that there seems to be some role for a ‘total fairness’ analysis. [unclear] Interplay with Delaware Law:

o Under Delaware §141(e) directors are allowed to rely in good faith on reports made by officers.

o Note: Delaware amended §102(b)(7) (NY amended §402(b)) in response to this case, allowing corporate charters to eliminate directors’ liability, except in certain circumstances. – response to the “consternation and anxiety” this decision created Exculpatory provisions for directors for loss/risk (with an exception in DE for breach

of fiduciary duty, bad faith, and conflicts of interest, and in NY for bad faith or conflicts) can be put into articles of incorporation. As long as they don’t limit the liability for breach of loyalty duties

Formally adopted provisions (initially or by amendment) provide notice for s’holders that directors may escape liability, they invest at their own risk

Policy – provide protection to encourage people to still accept positions as corp directors

7. Disney Litigation - Brehm v. Eisner (Del.Sup.Ct. 2000, and 2 nd case) Directors accused of failing to inform themselves about the total costs and benefits of an

employment contract by which Ovitz stood to make more $$ if fired

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o Initial decision was reached without the plaintiff having an opportunity for discovery. Evaluating the decisionmaking process, were directors entitled to rely on expert’s advice in

making the decision? YES.o Under Delaware §141(e), Board can rely on a qualified expert. To defeat a motion for

dismissal based on prima facie reliance on an expert, plaintiff must prove: Directors did not in fact rely on expert Reliance was not in good faith Did not reasonably believe that expert’s advice was within area of expert’s

professional competence. Expert not selected with reasonable care Subject matter so obvious that Board should have overruled expert’s advice Decision by Board constituted waste or fraud

o To overcome dismissal (due to lack of excuse), plaintiffs must use ‘tools at hand’ to show particularized facts that would allow for excuse. Note that these ‘tools at hand’ include shareholder rights of inspection (allowed under Delaware §220).

o The concept of “substantive due care” is foreign to the business judgment rule: Due care in the decisionmaking context is process due care only.

o Disagreement with the board’s decision is not enough when there is disinterest and absence of fraud.

General Proposition of 2nd Case - Abject failure to investigate is a failure of good faith and is outside the business judgment protectiono Claim alleging that board failed to ask, inquire, delay until more info was made available.

That the facts, if true, do more than portray directors who were negligent or grossly negligent in informing themselves, that they consciously and deliberately failed to satisfy their obligations. Transforms negligence claim into a breach of good faith claim

o No protection from corporation’s §102(b)(7) provision because there was a breach of loyalty and bad faith

o There is a certain level of indifference that goes beyond negligence to willful conduct that is unfaithful. Two components of the duty of care: 1) good faith; and 2) business judgment – need a real decisionmaking effort

Planning – all these cases indicate that board decisionmaking should be monitored more closely, insure that the board deliberates, documents deliberation, bring in experts, evaluate alternatives, etc

8. Francis v. United Jersey Bank (N.J. 1981) – Duty of Care Mrs. Pritchard (old drunk woman) inherits her husband’s share of family business, and sons

bleed it dry under her nose. Trustee of company brought suit on behalf of creditors. Did she violate her duty of care? YES. She was personally liable (effectively piercing her

estate to hold her sons liable), breached her general management duties to corp by failing to notice this egregious activity. (Note that money-management businesses often held to higher standard in such areas.) And this failure was a proximate cause of the loss (necessary for director negligence to lead to liability)o Even though they are prepared by officers and experts, financial statements may give rise

to a duty to inquire further into matters revealed by those statements. Upon discovery of an illegal course of action, a director has a duty to object.

o Members of the board of directors have obligation to exercise business judgment. Must either act to satisfy obligations or get off the board. Can’t escape liability by being a passive member or not going to meetings or registering dissents.

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Lesson: Sitting on the Board is not an honorific position, even in a closely held family business. If the closely held corporation goes bankrupt, the trustee can sue on behalf of creditors.o Planning matter – make sure that people who are involved in management are identified,

closely documenting their observance of business judgment/management rules, and that those people who are more removed don’t do anything that looks like management control

General Rule: Directors are under a continuing obligation to keep informed about the activities of the corporationo Director should acquire at least a rudimentary understanding of the business of the

corporation. Because directors are bound to exercise ordinary care, they cannot set up as a defense lack of the knowledge needed to exercise the requisite degree of care

o And fiduciary duties, standard of care applies with equal force to board of a closely held corp as it does to board of publicly traded corp Duty is for the benefit of the corp, only indirectly for the s’holders Requirements to manage carefully apply to whoever is actually running the corp

9. In re Caremark International Inc. Derivative Litigation (Del.Ch. 1996) Caremark settled with shareholders who brought a derivative action to recover losses from

Medicaid fraud and problems w/ Caremark’s management structure Was the settlement fair and reasonable or a breach of duty of care? It was reasonable, because

P’s claims that Caremark directors breached their duty of care were weako Discussing obligation of directors under bus judg rule to enact informational standards

and stay reasonably informed of corp developmentso On Board’s duty to monitor operations of corporation: absent grounds to suspect

deception, neither corporate boards nor senior officers can be charged with wrongdoing simply for assuming the integrity of employees. Only sustained or systematic failure of the Board to exercise oversight can establish lack of good faith.

Lesson: The process of submitting to settlement is not a rubber stamp. Courts will look with some care at the merits. o Compliance with director’s duty of care can never be appropriately determined by

reference to content of decision apart from rationality of process employed. The business judgment rule is process oriented and informed by a deep respect for all

good faith board decisions. If shareholders thought themselves entitled to some other quality of judgment, they should have elected other directors

Siegel : Is this still valid after Disney? We don’t knowo Sarbanes-Oxley requires that financial statements be accompanied by certification by the

president and DFO that they’ve read them and to their knowledge they don’t contain any material misrepresentation.

XIX. Duty of Loyalty

1. General Observations Note that under the Restatement of Agency (Second): “Unless otherwise agreed, an agent

who makes a profit in connection with transactions conducted by him on behalf of the principal is under a duty to give such profit to the principal.”

Conflict of Interest Concerns/Issues:o General conflict of interest – board member is personally interetested/invested in the

business affair, may not be able to square personal loyalties with demand of unvarying loyalty to the corp

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o Most of these are cases in which a director is both an official of the corporation and a contractee (e.g., director is selling something to company or buying shares).

o Directors should have unvarying loyalty to the corp, but they may also be working on transaction in which they or people close to them have special interests

o How to deal with conflict of interest? Common law rule said that transaction between corporation and director was

voidable by shareholders. Modern legislation reverses common law presumption. Contracts are voidable, but

not facially void. All contracts are allowed on their face if they fall under certain categories: Full disclosure Ratified by fully informed shareholder vote To be airtight, might want to recuse interested shareholders from vote. This is

desirable but not required. Might there be circumstances where it’s necessary or desirable to have directors on

both sides of the transaction? Reason to not automatically void… There are transactions where the entire board is interested, but it’s still in

everyone’s best interest to have the transaction go through Related companies – when all board members of one have a stake in the results

of a transaction Personal board shareholding – board members are s’holders inherently

interested, but that might make them more inclined to act in corp’s best interest Compensation decisions – board votes on board compensation are inherently

interested Litigation decisions – directors might also be facing personal liability

Corporate Opportunity Doctrine: If a transaction is in line with corporate business and is of practical advantage to corporation, then a director must fairly present the opportunity to the corporation first.o Two circumstances where Corporate Opportunity Doctrine applies:

Director uses company information or is acting in a capacity where a solicitor would reasonably believe he is dealing with the company.

Director comes across any opportunity in the corporation’s line of business that would be of practical benefit to the corporation.

Dominant shareholders have a duty to minority shareholders.2. RMBCA

§§ 8.60 – 8.63.o §8.61. Establishes total fairness test in cases where ratification did not take place.o §8.62. ‘Qualified Directors’ (i.e., disinterested directors) may vote to ratify transaction or

appoint a committee to ratify the transaction.o §8.63 talks about ‘qualified shares’ (i.e., disinterested shares) being the only shares able to

vote in ratification of interested transaction. Fliegler – need a disinterested vote to save/protect challenged transaction, interested

votes won’t help…3. NYBCL

§ 713o No contract or other transaction between a corporation and one of its directors (direct

interest), or with a related company, or with someone having a direct financial interest shall be either void or voidable for this reason alone, or for reason alone that there are interested parties

o §713(a)(1-2) tests for interested contract.

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If material facts about interest are disclosed in good faith, known to board and board still approves transaction by majority vote of disinterested parties, or unanimous vote of minority disinterested parties NEED good faith full disclosure – addresses equitable concerns 2nd option addresses problem of interested majority, requirement of quorum for

valid board meeting If board approval won’t work go to shareholders for a vote Courts have the power to look into the transaction and rule equitably.

o §713(b) in case contract fails §713(a) tests, must prove ‘entire fairness’ of transaction, which is a high standard. Corp may avoid contract/transaction, if they want to, unless the party or parties thereto

shall establish affirmatively that the transaction was fair and reasonable to the corporation at the time it was established

Essentially a financial fairness evaluation – was transaction financially fairo Transaction can be approved:

1) by disinterested directors or committee, unless there was failure to disclose the transaction;

2) shareholders, after full disclosure, can vote for approval; or 3) if the transaction is not approved in one of the former ways, the corporation can void

the contract unless the parties “establish affirmatively that the contract or transaction was fair and reasonable as to the corporation at the time it was approved by the board, a committee, or the shareholders This is the entire fairness test – in most jurisdictions, you won’t reach this test if (a)

(1) or (2) is satisfied. The problem of using the test is that then you must have a hearing on the merits – takes too long, makes the transaction much more expensive

o Consequences – must get some sort of disinterested approval up front, or risk mandated court involvement on the entire fairness issue Without prior approval, transaction open to challenge on fairness, risking TRO against

transaction, which would shut it down automatically §714. Corp may not lend money to or guarantee the obligation of a director unless

o Particular loan is approved by shareholderso Or corp certificate of incorporation provides for such loanso And board determines that loan benefits the corp, and approves specific loano Result of Sarbanes-Oxley – took on the flexibility of loans to directors, cut down on

possibilities for fraud through loan channels4. Bayer v. Beran (N.Y.Sup.Ct. 1944) – Duty of loyalty, directors and managers, conflict of

interest Board of directors is accused of self-interest when the wife of the president, an opera singer,

is hired to help with their radio show advertising. Was this a conflict of interest? Was the transaction invalid? NO.

o Whereas, under the business judgment rule, only in an extraordinary case would a director be held liable for negligence in the absence of fraud or improper motive, transactions that may tend to produce a conflict of interest are examined with the most scrupulous care, and if there is any evidence of improvidence or oppression, any indication of unfairness or undue advantage, they will be voided. – But this is under old law…

o But after careful scrutiny, no breach of fiduciary duty Wife did not receive special treatment in terms of billing or salary. Board’s decision to renew advertising contract was essentially an act of ratification.

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Textbook said that Bayer’s reasoning was: because contract was fair, it is valid even though the disinterested Board had not formally ratified it (or maybe the standard for ratification was lower). – Bayer fairness test…

This case would now be covered by NY §7135. Lewis v. S.L. & E., Inc . (2nd Cir. 1980) – Conflicting Director Interests

Founder broke business into two corporations in order to insulate liability and minimize estate taxes, while dividing the business according to the interests of the parties (i.e., actively interested in management versus not interested). Family members in one corporation sue their relatives who have stock in both for wasting corporate assets by not paying enough for lease of tire storeo Planning issue - If they had originally set the terms of the lease to provide for automatic

adjustment of the rental account to comparable levels, they would have avoided this Conflict of interest sufficient to void the transaction? Breach of duty of loyalty? YES.

Transaction was not proven to be fair and reasonableo Court followed common law rule: in case of an interested board, the directors have to

prove that the interested transaction was reasonable and fair. This transaction wasn’t. o Business judgment rule, which places a heavy burden on shareholders who would attack

corporate transactions, presupposes that the directors have no conflict of interest, so it does not come into play here

Siegel says, however, that some courts might find ‘shareholder beware’ because the parties did enter into an initial agreement.o Open question – under 713, if transaction is approved by a disinterested board majority or

shareholder majority, is court foreclosed from evaluating fairness? In CA – Suit allowed anyway, which defeats purpose of such a statute

If court retains power to evaluate fairness it will be impossible to get transaction approved in advance

In NY and rest of country – initial approval forecloses subsequent suits. Only way to challenge transaction: Argue that it represents corporate waste Argue that some element of approval process was corrupted Can’t argue that transaction was unfair

6. Broz v. Cellular Information Systems (Del. 1996) – Corporate Opportunity Doctrine Broz was President of RFBC and also on the board of a peer corporation [CIS]. He received

an opportunity that was not offered to CIS, though he individually contacted CIS people who said they wouldn’t be interested in opportunity.

Did he breach his fiduciary duties by not offering the opportunity directly to the company or to PriCellular, which acquired CIS? NO. His informal contacts with CIS were sufficient to disprove bad faith, and he had no duty to potential successor PriCellular at the time

Corporate Opportunity Doctrine:o Guth case said that director must offer opportunity to board if: (similar to Meinhart)

Corporation is financially able to undertake the opportunity If they can’t handle the opportunity, individual might be able to take it, but might

have to leave corp to do so Opportunity is in line with corporation’s business and of practical advantage to it.

Problem: If the company is highly diversified, the second category might include everything

By embracing the offer, self-interest of director would come into conflict with interests of the corporation

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General Rule: Can’t take advantage of the opportunity until it’s been offered to and rejected by the corporation. Must allow board to exercise independent business judgment or put it to a shareholder vote. Taking opportunities for yourself violates the fiduciary duty of loyalty. o Safer to always offer opportunity to boardo Safer also to put something about this in initial contract, articles – can contract out of

corporate opportunity doctrine, can contract to allow certain conflicting operations Though can’t contract out of all fiduciary obligations – but corps wouldn’t do it

anywayo Some indication that info came to Broz in a personal, rather than professional, context,

but most courts won’t look at that… duty of loyalty trumps 7. Sinclair Oil Corp. v. Levien (Del.1971) – Dominant Shareholders, Parent-Subsidiary

Sinclair owned 97% of stock in subsidiary Sinven, accused by minority shareholders of subsidiary Sinven of self-dealing and unfairness in its distribution of Sinven dividends because he had decided to drain Sinven of assets by announcing huge dividends. Complained that drain prevented Sinven from expanding.

Was Sinclair’s decision a breach of duty of loyalty? NO. Not ‘self-dealing’ because it paid equal dividends to minority shareholderso Board has duty of loyalty to corp, for the benefit of all s’holders. What happens when it’s

a dominated board? What’s the duty to the minority? o In case of parent/subsidiary transactions (where there are minority shareholders), the

proper test of board behavior is one of intrinsic fairness. But did they use business judgment rule because it wasn’t self dealing to evaluate the decision??? Which would lead to conclusion that motives are immaterial unless P can show

that the dividend payments resulted from improper motives and amounted to waste

o However, a contract between Sinclair and Sinven, which fixed price of oil Sinven would sell to Sinclair, was self-dealing. And Sinclair broke the contract, which would make it liable for a derivative suit from the minority shareholders ex rel Sinven.

Siegel : This prob isn’t good law, even in Delaware, prob a one off. Courts would now prob look into entire fairness of transaction.o Used the distribution of dividends as a technical way out of self-dealing charges, doesn’t

really address equity concerns that decisions were made to their real disadvantage, wasn’t really fair

8. Zahn v. Transamerica Corporation (3 rd Cir. 1947) Dominant shareholder TA knew about the increase in tobacco value, so they caused Axton-

Fischer to recall its Class A stock so that they could then liquidate the company and keep all the money for themselves. AF effectively took an end run around the call-back/conversion optiono Result of complex 3-class stock structure – differences in risk involved, dividends

offered, different call-back optionso Why issue stock like this? If stock does appreciate corp will be able to call it and

benefit, corp maintains ability to retain value Corps might issue callable stock to reduce amount of dividends paid

Were the stock manipulations/transactions a breach of fiduciary obligations? YES, the call to redeem the class of stock was voidable in equity.o Corp has to abide by the stock terms, has duty to minority - majority has a right to

control; but when it does so, it occupies a fiduciary relation toward the minority, as much so as the corporation itself or its officers and directors

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o Here, since the transaction was dominated by the majority, dominating board has to prove fairness of underlying transaction in order to prove fairness, satisfaction of duties to minorities…

o Most states will say that a share is a contractual right and fiduciary duty doesn’t go further.- Corp couldn’t call and dissolve (rather than convert) in a way that undermines the contractual rights to converted stock…

Remedies available to court include:o Void transactiono Impose remedial damages to make transaction fair.

9. Fliegler v. Lawrence (Del.1976) – Ratification, only in dominated corps… Director attempted to sell land to his corporation through a corporation that he formed. Ds

claim that shareholder vote ratified their interested transaction and so they are relieved of the burden of proving fairness.

Did shareholder vote ratify the transaction? Eliminate need to prove fairness? NO. But Ds ultimately proved intrinsic fairness of transactiono Ratification of interested transaction by disinterested shareholders shifts the burden of

proof to the plaintiff to show the transaction amounted to a gift or waste.o Because interested shareholders voted, the vote does not immunize interested directors

from total (intrinsic) fairness examination. Interested shareholder votes don’t help. General Rule – s’holder vote won’t really ratify a transaction if it is not a disinterested

s’holder vote.o If court is going to apply a standard based on s’holder approval court will look at

s’holders, insist on disinterested approvalo ONLY in dominated corps

10. In re Wheelabrator Technologies, Inc. Shareholders Litigation (Del.Ch.1995) – Ratification, not a dominated corp so Fliegler doesn’t apply Can a majority vote of disinterested s’holders ratify a transaction? YES.

o When a controlling shareholder is involved in a transaction, ratification of a ‘majority of the minority’ does not eliminate the ‘total fairness’ examination. It simply shifts the burden of proof from defendant to plaintiff.

o BUT w/o a controlling shareholder, ratification of interested transaction triggers only business judgment rule (plaintiffs have burden of proof). Disinterested vote immunizes directors against both loyalty (interested transaction)

and care (waste) claims. General Rule: Independent ratification by majority vote satisfies the duty of loyalty:

o Burden of Proof issues - now on the person opposing the transaction on the basis of waste/unfairness to prove that the transaction was outside business judgment.

o If there’s majority disinterested approval burden on objectorso If there’s no majority approval burden on directors

FEDERAL SECURITIES LAWS

XX. Federal Corporations Law: Generally

1. History Corporate law started as state law – variable and variably enforced Federal Intervention

o Catalyzed by the Great Depressiono Congressional conclusion that dealing with investors, investments, shareholders should be

taken as a federal matter – to guarantee and standardize protection

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2. Structure of the Federal Securities Law Regime 3 possible options – could have been a combination as well

o Substantive regulation – based on character/quality of product and corp Ex: Regulations limiting what can be sold and by whom We have substantive regulatory schemes in other areas, securities regulation is NOT

substantiveo Merit regulation – not substantive regulation of the corp, but regulation that decides

whether corp can issue stock at all Ex: blue sky laws – administrators determine that corps don’t have a right to sell

certain interests/ securities Decision about risk – whether acceptable or unacceptable risk attached to possible

stock saleso Disclosure regulations – regulation that mandates that full, fair, adequate info be disclosed

and as long as disclosure is made, anything can be sold Elements of a disclosure regime: Need to know

Subject of regulation – what sort of security is being regulatedo What’s a security – stocks, bonds, various investment contracts and financial

instruments broadly construed Info to be disclosed – detailed catalog of mandatory disclosure Disclosure process – how we actually regulate, how info is disclosed and to whom Enforcement – how overall system is enforced/policed

SA and SEA are disclosure regulationso Chosen by federal government because it encourages higher levels of risk and process of

capital formation. You can take your own risks as long as the risks are fully disclosed by the

corporationo Purpose of disclosure regime – help market become a ‘fair game’

Outcome is up to participants, but playing field is level, bounded in certain ways by information rules.

o Address 2 core concerns: Fiduciary obligations – care, loyalty, honesty, conflict of interest The market – protect, but defer to, the market

Accountability determined by the market Ownership notion – people can buy, own, risk what they want… and the gov’t

shouldn’t intervene to protect them from it Represents commitment of faith to validity of a rational market – underlying theory

that supplying buyers and sellers w/ adequate in kind, appropriately vetted, subject to anti-fraud provisions info they as a marketplace will form appropriate opinions market will rationalize itself

o Fundamentally a delegation of authority to the SEC – provisions prohibit actions “in contravention of such rules prescribed by the commission…” Delegation is key to fed securities regime – allow SEC to define the substantive

conceptso Similar purpose, similar in scope – but not fully integrated

Actual disclosures may be uniform or integrated, but they are still separate laws Process of Issuing/Selling Stock

o Once a company files with the SEC, the staff conducts a prima facie investigation, but does not audit the company.

o Then you can distribute a preliminary form of the prospectus to potential buyers

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o Between filing and effective dates, a preliminary statement or ‘red herring’ is circulated among investors, who can sign up for allocations.

o Once the prospectus becomes effective, you can sell o There are specialized marketers (underwriters and dealers) because initial public offerings

of stocks must sell quickly or they will ‘go bad.’ Underwriters may do ‘best effort’ (i.e., gives back unsold stock) and ‘full’ (i.e., buys whole block of stock).

o System designed to ensure that prior to buying stock or security, certain information gets into the hands of the potential buyer

3. Recent Federal Developments 1st change – foreign corrupt practices act

o More substantive - internal information system that provides the corporation with information such that it can prevent the making of certain payments

2nd Change - Sarbanes oxleyo More intrusive substantive regulation (though some disclosure-related provisions) -

prohibition of loans to directors and officers, etc, are NOT disclosure-orientedo Using fed securities law and interstate commerce powers to federally regulate substantive

corporate law Future – Additional compensation-related problems may lead to more federal regulation on

corporate compensation structureso There are already provisions in the internal revenue code to support it

4. Evaluating the System: Do the laws work? Yes. Without the regulation we would not have a functioning securities market to the degree we

now have Yes. Because the SEC does a good job

o Fills in the blanks of the underlying securities acts, and SEC rules give rise to the details of liability

o Legislative and judicial body – makes rules and judges securities disputes/issues penalties Does the elaborate disclosure structure produce info that is useful for the investor?

o Not quite the right question - Not whether particular 10-K helps the investor, but whether document and entire system makes it likely that investment will be made on the basis of all the facts as they’re truly understood

o Yes. For the most part, info is incorporated rapidly into the market, does make a difference But full impact of new info may not be incorporated immediately or even quickly

No. Structure just made process more formalized, elaborate and expensive without bringing substantive benefitso Might not need to be this elaborateo Anti-fraud structure might have been enough to force disclosure of critical partso Our system might not be cost effective

XXI. Federal Corporation Law: 1933 Securities Act - deals w/ the primary market, IPOs etc

1. Securities Act of 1933, as amended (“SA”) General Observations:

o Single transactional act – requires disclosure in conjunction with a public offeringo Thresholds – coverage turns on 2 factors

That what is involved/being offered is a security That there is a public offering that is not otherwise exempt

o 3 sections concerned w/ liability – 11, 12, 17 § 2(a). Definitions. Note the non-exhaustive (but large) list of examples of securities.

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§4. Exempted Transactions – specific exemptions to §5 presumption of coverageo Offers exceptions to registration requirements for certain types of securities. Some

securities entirely exempt from registration, some specific transactions in securities otherwise not exempt might be exempt An exempt security need never be registered, either when initially sold by the issuer or

in any subsequent transaction Exempt transactions are usually one-time transactions – more typical exemption

o §4(1). Any transactions by another person besides the issuer, underwriter, or dealer (i.e., any secondary market transactions).

o §4(2). Sales by issuer not involving a public offering. §5. Prohibitions relating to interstate commerce and the mails (tied to registration process too) –

it’s unlawful to trade in unregistered securities, violations of §5 are some of the biggest SEC crim actionso Allows for criminal penalties – and this DOES lead to litigationo 3 requirements:

Security may not be offered for sale through the mails or by use of other means of interstate commerce unless a registration statement has been filed with the SEC

Securities may not be sold until the registration statement has become effective Prospectus (a disclosure document) must be delivered to the purchaser before a sale.

o §5(a). Prohibits trading except after registration statement is filed and in effect.o §5(b). Prospectus must meet requirements of section 10. All securities must be

accompanied by a prospectus.o Threshold issues – only applies to securitieso Registration Details: The SEC reviews the registration statement on its face – not to see

whether or not it would be a good investment, but whether it contains required disclosures and information appears accurate. The core of the registration statement is the prospectus – Until SEC has approved the disclosures made in the prospectus, companies cannot sell the new securities.

o Presumption of coverage exemptions are drawn elsewhere Party claiming act DOESN’T apply has the burden of proving that At the trial level, the presumption is that it is a security, is a public offering, isn’t

exempt Defendants will have to demonstrate that their actions fall outside the boundaries of

§5 §8(a). Registration statement is good 20 days after filing, unless SEC finds that it is incomplete

or inaccurate and requires changes. §10. Information required in prospectus - Requirements for registration statement.

o Tied to §5(b) liability – liability to trade in securities if prospectus hasn’t met requirements of §10

o Concerns: communication of potential deals might count as a prospectus – informal prospectus might trigger liability

§11. Civil liabilities for false registration statement. (private cause of action)o §11(a). Any person who has acquired a security with a false registration statement may

sue directors, partners, experts, and underwriters.o §11(b). For non-expert sections, there is an exemption for due diligence, reasonable

investigation – still higher than general reasonable care, actually requires action (and costly – costs get passed on to investors) No person other than issuer shall be liable if he shall sustain burden of proof

Issuer always liable Others can escape

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Due diligence is not an affirmative obligation, but all rational participants in a public offering perform it because it is the only viable defense to a § 11 claim. That job usually falls to lawyers

Standard of care – If D proves he satisfied it, can escape liability Non-experts – after reasonable investigation, D had reasonable grounds for

believing and did believe that statements were true Experts – reasonable investigation according to professional standards, tailored to

particular role played/section expertised o §11(e). Damages valued at difference between purchase price and the time of sale (before

suit) or time of the suit. Defendant can lower damages by demonstrating that part of the loss of value was due to other factors besides omission or misstatement.

o §11(g). Damages can only be up to price of security.o SA § 11 is the principal express cause of action directed at fraud committed in connection

with the sale of securities through the use of a registration statement – targets material misrepresentations in the registration statement Because material misstatement or omission must be in the registration statement, § 11

cannot be used with exempt offerings. Neither reliance nor causation are an element of P’s prima facie case – instead, burden

shifts to D to prove that its misconduct did not cause P’s damages or prove that P knew of the untrue info at time of purchase D may reduce amount of damages with proof that the reduction in value was

caused by some other factor. § 11 contains no privity requirements, so the list of potential Ds is quite expansive.

Very controversial now Possible Ds: everyone who signed the registration statement, which by statute must

at a minimum include the issuer, its principal executive officers, and a majority of its board of directors; every director of the issuer at the time the registration statement became effective, including directors who didn’t sign; every person named in the statement as someone about to be a director; every “expert” names as having prepared or certified any part of the statement, or as having prepared any report or valuation used in connection with the statement; and every underwriter involved in the distribution.

Expert liability only connected to part expert actually worked on, consented to be tied to

Standards of proof Not that of the profession, but a standard that fits this section Unlike SEA §10(b), no requirement to prove scienter. If P proves prima facie case

D can be held liable even if the misrepresentation or omission was an inadvertent mistake.

As to Ds other than the issuer, the degree of fault required is negligence standard. Burden of proof on Ds to prove that they were not negligent in connection with the preparation of the registration statement.

§12. Civil liabilities arising in connection with prospectuses. (private right)o §12(a). Strict Liability for offering or selling a security in violation of section 5. Or for

any untrue material statement in prospectus. P need not show reliance or “scienter” or intent – negligence is sufficient. Action is for rescission of purchase - consideration paid, plus interest, less income

received on security.

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Absolute right to rescission - If registration was required, and P bought stock, which dropped in value, 12(1) allows P to return it, present it back to any person who offers, and get money back

Harsh remedy to induce real compliance § 12(a)(2) prima facie case: Untrue statement of facts on the prospectus

1) the sale of a security; 2) through instruments of interstate commerce or the mails; 3) by means of a prospectus or oral communication; 4) containing an untrue statement or omission of a material fact; 5) by a D who offered or sold the security; and 6) which D knew or should have known of an untrue statement (if P pleads D’s knowledge, burden of proving otherwise shifts to D

Only applies to initial offerings, not to statements re: secondary transactionso So doesn’t conflict with 1934 SEAo But broader than registration requirement, covers non-registered transactions

§17. Fraudulent Interstate Transactions. (criminal sanctions)o §17(b). Must disclose any consideration for promoting or publicizing a security.o 3 categories of fraud – unlawful to

To employ any device, scheme, or artifice to defraud to obtain money or property by means of any untrue statement of a material fact or

any omission to state a material fact necessary in order to make statements not misleading…

to engage in any transaction, practice, course of business which operates or would operate as a fraud or deceit upon the purchaser

Language becomes the core of 1934 §10, core of rule 10b(5) core of civil damages liability later on…

2. SEC Regulations: Rules 501-06 (Regulation D): Allows “safe harbor” exemption for securities that raise

relatively low amounts of money, allowing them to avoid registration and required disclosure. Issuers must make reasonable effort to ensure that buyers will not resell the securities, “reasonable inquiry” into buyer’s plans and disclose to the buyer that the stock is unregistered, and print resale restrictions on the stocko issuers can use to come within the private-placement exemption and avoid (or reduce) their

required liability: 1) if issuer raises no more than $1 million through securities, it may sell them to unlimited number of buyers without registering them; 2) if it raises no more than $5 million, it may sell to no more than 35 buyers; 3) and if it raises more than $5 million, it may sell to no more than 35 buyers, and each buyer must pass various tests of financial sophistication.

o Issuer prob cannot widely advertise the security, and in all cases must file with the SEC a notice of the sale shortly after it issues the securities. Must still give some reduced amount of information about the company to the buyers.

o The limits on number of buyers do not apply to “accredited investors” – in general, banks, brokers, and other financial institutions and wealthy buyers.

o Exempts only the initial sale, so most buyers can only resell the securities if they find another exemption (not “an issuer, underwriter or dealer,” for instance).

3. The 10-K Report – prime example of how info accessible registered companies are. Can’t find out as much general info about non-registered corps Overall Structure – reviewed for disclosure sufficiency, but not for substantive accuracy at time

of disclosureo Introductory piece w/ general info

Descriptive Materials. Historical and requires corporation to disclose ‘risk factors.’ Also requires disclosure of legal proceedings that are still pending.

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Management Discussion & Analysis. Elements relating to their stock and how it is traded. Disclosure of ownership of stock, equity compensation

Discussion of problems facing the corp – not in the best possible light but w/ a fairly skeptical view The “impartial” picture by all filed documents is actually slightly negatively biased Safer for investors if things look less rosy

Why disclose all this? liability document, so anything that might be material omission or misleading by omission “entire palette” of potential punishment and penalty Tilt of disclosure towards more rather than less

o Middle piece w/ financial info – the most current info and a full context for corp’s financial operations over time Corp management vouches for the financial info disclosed

corporate officers’ own statements, under their responsibility and authority, and that they have delegated authority to the auditors, etc

Validity of these statements? If they make the statements, does it make it impossible for presidents, etc, to then claim that they didn’t know what was in the financial statements? Siegel : minority view, yes. Predominant view: particular representation was not specific enough, in criminal

and maybe in civil liability terms, to attach personal liability to the people who signed ito Signature doesn’t always mean personal awarenesso View led to Sarbanes oxley – where chief executive and financial officers

explicitly make a representation to their own personal knowledge, additional assurance of personal involvement and knowledge later in 10-K Why? can’t let the officers off the hook any more, you say you saw the

report so you’re responsible for it. Set up some liability they can’t get out of…

Financial statements – statement of income, balance sheet, statement of cash flows, all to describe financial performance/position of company

o Final piece w/ various undertakings, details about compensation plans, executives Other Disclosures (e.g., insurance, stock options, etc.)

Ultimate importance – that regulatory structure requires 10-K be prepared, filed, publico Mandatory disclosure of so much more info than previously requiredo Subject to strict penalties for material mistakeso Keep in mind that all disclosure is historical – even w/ online disclosure there’s some time

lapse4. Great Lakes Chemical Corp. v. Monsanto Co. (D.Del. 2000) – What is a security? Registration

requirements. M tries to avoid liability for failing to disclose material information in conjunction with sale of

NSC by claiming that interests sold were not “securities.” Were the interests securities? NO. Investment contract interests in NSC constitute neither

“stock,” nor an “investment contract,” nor “any interest or instrument commonly known as a security.”o Interpreting §2(a)(1) of SA (effectively same as definitions in SEA)o Underlying issues – how technically or equitably do we define “security”? How is that

definition used to set coverage limits/scope of fed securities laws? Critical summary of preceding cases:

o SEC v. W.J. Howey (U.S.1946) : Florida corporation sold individual tracts of land in an orange grove, and then took exclusive control of the property through service contracts. To

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see whether the individual tracts constituted ‘securities’, Court looked at three requirements: (current test for investment contracts to be securities, but only for investment contracts) An investment of money In a common enterprise With profits to come solely from the efforts of others Defining the term to better address underlying interests driving SA – protect investors

in an operation who need info about nature of the investment This was the type of investment that required mandatory disclosure of info Promoting the spirit of the law

Cf: Partnership interests are usually not securities because there isn’t the expectation of drawing out a share of the profits from the efforts of someone else.

o United Housing Foundation v. Forman (U.S.1975): Non-profit housing cooperative sold share of ‘stock’ – the sole purpose of which was to allow purchasers to occupy an apartment in the coop. Real Issue – was this the type of “stock”/scheme congress felt required protection of

term security and application of securities law? NO. Name “stock” was evidentiary but not dispositive. Looked at 5 most common features of stock: Need stock in substance as well as form Right to receive dividends contingent upon an apportionment of profits Negotiability, transferable interest Ability to be pledged or hypothecated Voting rights in proportion to number of share owned Ability to appreciate in value

Turning point in fed securities law – laws being read too broadly, this cut back Look to spirit of law – don’t need fed intervention here Esp since state law protected interests – real estate prospectus sufficient

o Landreth Timber Co. v. Landreth (U.S.1985): If you buy 100% of a corp, and it looks like stock, is transaction covered by securities laws? Howey only applies to an “investment contract” and not to any of the other devices

listed in SEA §2(a)(1). Not applicable because the LLC membership interests, while “stock-like,” were not

stock. Howey test controlled since profits would not come solely from the efforts of others, the

LLC membership interests were not an “investment contract” within the definition of Howey. Siegel : Landreth is a lousy holding b/c the sole buyer has enough bargaining power not to need

disclosure protection of SA. o substantive nature of transaction was sufficient protection, if buyer buys all, he has enough

leverage to demand info personally, w/o federal intervention Definition of a Security: Very easy mistake to fail to recognize a security.

o Knowing whether or not a particular type of instrument or investment is a security is important for two reasons Tells you whether the registration requirements of SA apply to the transaction Ps have a much easier time bringing fraud claims under the securities laws than under

state common law fraud rules – the elements of federal securities fraud are less demanding, easier to prove and there are procedural advantages (liberal venue).

5. Doran v. Petroleum Management Corp. (5 th Cir. 1977) - §4 Exemptions Were sales of LP interest in oil drilling venture part of a private offering exempted by § 4(2) of

SA from the registration requirements? NO, not exempt

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o §5 prohibits sale or offering (in interstate commerce) without filing/effectiveness of registration/prospectus. UNLESS outside interstate commerce or covered by a §4 exemption. Here, possibly §4(2) – transaction not involving a public offering

o In the absence of findings of fact that each offeree had been furnished information about the issuer that a registration statement would have disclosed or that each offeree had effective access to such information, this is not an exempt private offering Insufficient to follow structure of the private offering exception – need to show that

offerees have the sophistication to get the info needed or else in some other way have the info

Look to spirit of law, determine whether persons affected needed protection of acto Public/private offering line determined by (connects to Ralston Purina – not exempted

private offering b/c too many offerees) Number of people solicited

Not how many people bought but how many were offered Amount of money involved Number of units offered Size Manner of offering Relationship between parties and information available to investor.

Consider info’s coming from and how – if investors only have info being given by the corp, and aren’t on equal footing w/ corp have less leverage to get more or all info

In a private offering, offerees must have available information equivalent to that afforded by a registration statement for a public offering. Parties must be able to get the same level of info w/o mandatory fed disclosure.o Availability means disclosure or effective access to relevant information.o Corp must prove that offering included all info that would have been made available under

the fed lawso How do private offerings really work?

Amounts must fall within limits of regulation D Offers typically to highly sophisticated, connected investors – people w/ appropriate

experience/leverage to get all the info Accompanied by a private prospectus – essentially the same thing but can be in a

different or informal format, and w/ some documentation that each potential investor got and read it

Examples: private offerings to banks, institutional investors6. Escott v. BarChris Construction Corp. (SDNY 1968)

False statements on registration statement. Did Ds’ (all possible parties sued) “due diligence” defenses protect them from liability? NO.

All parties liable, no claims of reasonable investigation were sufficient.o Applying reasonable investigation standard and none passed

not burden of due care, but very specific burden – must prove that he made a reasonable investigation, had reasonable grounds to believe that everything was fine, and actually believed that everything was fine. Reasonable belief of an expert is an expert standard of care, not an ordinary man standard of care (like the board of directors).

The liability of a director who signs a registration statement does not depend upon whether or not he read it, or if he did, whether or not he understood what he was reading. (objective reasonableness standard)

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Can’t just rely on experts if you have reason to believe they’re wrong. Reliance on experts doesn’t prevent liability. Requiring check on easily verifiable matters isn’t unreasonable.

Even applies to outside directors – they’ll probably be pushed further outside of they really do “reasonable investigation” but still required to

o Related issue – standard of materiality. How much of a misstatement is material? The numbers here were routinely wrong by 10%, clearly material. Material = the kind of information that would enter into the mix that a prudent,

ordinary investor would consider when deciding whether or not to invest.

XXII. 1934 Securities Exchange Act – Deals with the secondary securities market, everything beyond the initial offering

1. Securities Exchange Act of 1934, as amended (“SEA”) General Observations – covers all dealings affecting a security after the initial offering, unless

specifically exempt. Puts system of continuing disclosure into placeo Most important aspect is the private right of action created by SEC Rule 10-b(5).o Effectively all publicly traded companies (500 or more shareholders) as well as some large

close corporations (value over $1 million) are required to file Exchange Act reports: Annual 10-K, quarterly 10-Q, and special/periodical 8-K. **Be careful to distinguish registration of a class of securities under the Exchange

Act (filing an initial Form 10) from registration of an offering of securities under the Securities Act (registration statement) – a company that has registered a class of securities under the EA will still have to register a particular offering of securities of that class under the Securities Act. Although slightly inaccurate, it may be helpful to think about the difference as follows: the Exchange Act registers companies; the Securities Act registers offerings.

Underlying theories – Fraud on the Market and Efficient Market Hypothesiso Conception that markets react efficiently and immediately to new information

Implies that market acts as an “unpaid agent” of the investor, informing him that given all of the information available, the value of the stock is worth the market price.

But keep in mind that efficient market is very accurate at representing what everyone thinks everyone else is thinking… reflects consensus, not necessarily accurate value or accurate picture of the future

Note: in ‘fair market value,’ ‘fair’ modifies ‘market’ rather than ‘value’ – the fairness comes from the fact that the outcomes should be bound by the rules of the market.

o Weak Form – arguing that past history of price movement is already built into current price, so that trends don’t affect prices, movements have already been incorporated…

o Semi-Strong Form (Basic v. Levinson) – arguing that all PUBLIC information, info that’s available, is rapidly incorporated into the pricing of stock Corollary – public dissemination of false information, that no one knows is fals, will

also affect the price fraud on the market theory Information affects the market instantly, that’s guaranteed, but it still may take some

time to fully comprehend the implications and feel the full effect Depends on the complexity of the information

Supreme Court accepted this notion on Basic. As has SEC, where integrated disclosure is tied to this – recognize that info disclosed

with the first filing will be incorporated into the market no need to duplicate certain disclosures

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Consequences – places a high premium on seeing that info becomes public and that the info that becomes public is not corrupt Why we have a market structure that imposes penalties for disclosure of false

info…o Strong Form (West v. Prudential) – arguing that the market rapidly responds to ALL

information, public or not Possible? If market doesn’t know about things going on, how can it react?

It does to a certain extent – Texas Gulf Sulfur where prices moved even before info was made public

Recognize that info is never totally undisclosed, and nonpublic info can still affect stocks to some degree

Tangential info will serve as some sort of indicator… Insiders can/do make money based on info before outsiders

o Fraud on the Market Doctrine. Relies on efficient market hypothesis – idea is that stock value only changes with new information. Therefore, false information will affect the value for all stockholders, even if they did not rely on the information. If stock price is determined by available info misleading statements pollute the

market and can defraud investors even w/o direct reliance Causal connection between Ds’ fraud and Ps’ purchase is no less significant than in

cases of direct reliance on misrepresentations. §10. Manipulative and Deceptive Devices

o rogue/maverick § that doesn’t tie into the SEA registration requiremento For corp with 500 holders of securities and assets of more than 1 million (effectively a

publicly held security, even though prob not enough to be listed on major exchanges) it shall be unlawful for any person by any means of interstate commerce to: (a)(1) effect a short sale, or to use or employ any stop-loss order … in contravention

of rules by the SEC (b) use or employ in connection with the purchase or sale of a security registered with

a national exchange or not registered (this section applies to everyone) any manipulative or deceptive device or contrivance in contravention with any rules prescribed by the commission. Totally all inclusive – general federal anti-fraud provision, applies to any

securities transacted through interstate commerce And the standard is whatever the commission prescribes as being in the public

interest or for the protection of the investorso Total delegation to the SEC to

Rule 10b-5 – Implied right of action under §10, implied civil damage remedy from initial criminal liability (Carden)o Incorporates language of SEA §10 and SA §17 – unlawful for any person by use of

interstate commerce, mails, nat’l securities exchange in connection w/ purchase or sale of a security: To employ any device, scheme or artifice to defraud To make any untrue statement of a material fact or to omit to state a material fact

necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person

o Purpose – w/ both criminal and civil remedies, now used to protect overall integrity of the market

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Tied to corporate finance background – dealing w/ market for financial instruments, not as fungible as straight money so fraud has more of an impact

Also tied to efficient market hypotheses – how long does it take for info about a corp to affect price of stock? Effectively immediate, movement of market is nearly instantaneous

o Limitations Standing: “purchase or sale of any security.”

To have a civil remedy, P must who purchase or sale of security in connection with D’s act of fraud…o No cause of action if P claims lost money because P didn’t buy shares based on

false information.o There can be a 10b-5 violation if D does any of the enumerated wrongs and P

trades. Standing requirement is NOT a limit on SEC bringing a criminal action against D,

only a limit on private civil remedy Scienter: Negligence is not a sufficient basis for a 10b-5 violation. Requires intent on

D’s part to defraud, including recklessness. D must know statement is untrue, or act recklessly with regards to whether the

statement is untrue.o Secondary Liability and Scope of Interpretation: A lawyer or an accountant (or anyone

else) who aids and abets a 10b-5 violation is not liable. §12. Registration requirements for securities.

o §12(a). Makes it unlawful for brokers to trade a security on a national exchange if it hasn’t been properly registered.

o §12(g). This is the provision for integrated registration. §13. Allows SEC to set up rules for filing periodical reports and describes the types of

information to be listed in these reports.o §13(d). Requires owners of more than 5% of class of securities to report to SEC.

§14. Section dealing with proxy solicitations.o §14(a). Allows SEC to set up and enforce rules regarding proxy solicitations.o §14(c). Information sent to investors regarding annual meetings must be similar to that

regarding offer of security.o §14(e). Unlawful to make untrue statement in connection with tender offer.

2. Basic Inc. v. Levinson (U.S. 1988) – Defining materiality, Recognition of 10b-5 implied civil damages remedy and acceptance of efficient market hypothesis Basic was being acquired, and repeatedly publicly denied it, before finally admitting that a

tender offer had been made. Ps had sold their shares after the initial statements, but before the actual admission lost chance to sell at higher post-announcement, post-merger prices.

When does merger information become material? Where in merger negotiation process does corp need to tell s’holders? Is there a legit 10b-5 suit?o Materiality as a threshold issue – defined by TSC

TSC Industries, Inc. v. Northway (U.S. 1976): Test for materiality of omitted fact is whether “there is a substantial likelihood that a reasonable shareholder would consider it as altering the ‘overall mix’ of information made available.” Omitted fact is material if there’s substantial likelihood that reasonable s’holder

would consider it important in making the decisions like how to vote, invest, etc Also need to balance likelihood of event and the magnitude of its impact.

Low probability occurrences w/ huge impact might still be material, need to be disclosed

Rather than brightline “agreement in principle” standard

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Material info isn’t required to be disclosed, but can’t be disclosed untruthfully – a point where if corp chooses to speak, it must do so honestly

Drawing the materiality line for mergers: All tentative steps… Discussions begin.  Tentative oral agreement that there will be a merger.  “letter of understanding” – first milestone for setting basic terms, but NOT formal

agreement Conclusion of formal merger agreement, adopted by each board S’holders’ meeting, where the shareholders vote on the transaction. Closing Info re: merger prob not material until former merger agreement

What happens when misinformation is disclosed?o Truthful info would have pushed prices up (and did later) but misinformation artificially

deflated them. Ps want value lost b/c of false info.o 10b-5 doesn’t impose unconditional affirmative duty to disclose, but after crossing point of

materiality, misstatements or mis-disclosure are unlawful D could have said “no comment”. But public denials were a problem.

Reliance Issues – P in 10b-5 cases does not need to prove direct reliance on misinformation, can just presume investors’ reliance on integrity of market priceo There is a rebuttable presumption of reliance – the defendant can rebut by severing the link

between the misrepresentation and the price paid by the plaintiff. Prove there was definitely not reliance Ex: evidence that the “market makers” were privy to the truth about the merger, or if

Ps himself knew about the mergers but decided to divest their shares for unrelated reasons

Dissent: How do you know that the market believed the info from Basic? Implicitly arguing that market value on any given day is not the “true value” (if such a thing exists) of the stock

Siegel : Market price reflects consensus of mkt players based on honest information, not necessarily the true value of the stock.o SEA not trying to create a market that reflects true value, just trying to keep market from

being destroyed by misinformation.o Applying semi-strong-from economic efficiency – if honest info is disclosed will affect

market instantaneously. Some brief period of adjustment, but then quick stabilization.3. West v. Prudential Securities, Inc. (7 th Cir. 2002) (Easterbrook) – Strong form Efficiency

Stockbroker Hofman told 11 of his customers a lie about a company; on the basis of his fib, the stock price creeps upwards, and the public who bought at inflated price want to sue b/c stock went back down because info was false

Can other investors sue for fraud on the market, based on the private misstatements? NO, general public investors (not the ones he told) do NOT have a claimo Non-public information that affects the behavior of a few buyers does not necessarily raise

the price of the stock. This is because there are so many substitutes for a given issue of stock: if one becomes more expensive, investors simply switch to a different investment.

o Fraud on the market covers only publicly made misstatementso Rejecting strong-form market efficiency theory, under which the market price would also

reflect undisclosed facts Reflecting underlying debates about how info gets incorporated into the market

Siegel : Non-public info DOES affect the marketo There’s “upward drift” all the time – people can’t keep secrets. o Easterbrook limited 10b-5 fraud-on-the-market liability to public misstatements because

otherwise there would be too many claims brought.

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Raises issues of what is public disclosure – what’s public? What’s sufficient?o Could argue that form doesn’t matter as long as info is disclosedo SEC does NOT believe that – form is important, wants disclosure in its own way

Problem – not sure it’s necessary, and SEC’s way is expensive4. Pommer v. Medtest Corporation (7 th Cir. 1992) (Easterbrook) – Materiality

Company official told potential investor interested in buying the official’s stock that company had a patent, when the patent was still pending. Company ultimately received the patent.

Was statement material so that corp is liable for its falsity, the misrepresentation?o Securities laws approach matters from an ex-ante perspective: a statement materially false

when made does not become acceptable because it happens to come true. Need to be truthful when statements are made.

o However, the ultimate truth of the statement may affect damages.o Evaluation of risk – how should courts evaluate quantum of risk regarding info, how is risk

accurately conveyed to investors? The company is not liable for false statements made by the official in pursuit of his own

interests.5. Blue Chip Stamps v. Manor Drug Stores (U.S. 1975) – Standing for 10b-5 action

How does P get standing to sue for violation of 10b-5?o There must actually be a purchase or sale, and P must have participatedo D doesn’t necessarily have to participate – but D’s misstatement needs to affect P’s tradingo An overly pessimistic portfolio that discourages buying cannot be grounds for liability –

discouraging a purchase is not actionable General Rule: Standing requirement for a private civil action turns on the Plaintiff’s

participation in a transaction6. Ernst & Ernst v. Hochfelder (U.S. 1976) – Scienter in 10b-5 Actions

Nay ran a fraudulent pyramid scheme under the name First Securities. When the scheme ran dry, Nay shot himself, leaving a note admitting to the fraud. Hochfelder and other victims of the scheme sue Ernst, the accountants here, for failing to properly audit First Securities.

What’s the potential liability of CPA that had signed off on audit opinions negligently? NO liability. There’s a scienter requirement for 10b-5 liability, and there was no intentional misrepresentation, etc, here. E&E were negligent, even though Nay was intentional.o Negligence is not sufficient.o Need “intent to deceive, manipulate, or defraud.”

Recklessness later deemed sufficient as well Note in this respect the contract between 10-b(5) and SA §§11-12 in required level of scienter

for liability.7. Central Bank of Denver v. First Interstate Bank (U.S. 1994) – Aiding and abetting

There is NO ‘aiding and abetting’ liability under 10-b(5) Direct liabilities only.

8. Santa Fe Industries, Inc. v. Green (U.S.1977 ) - reach of 10b–5 re: Delaware short-form merger Short form merger occurs, under Delaware law, and eliminates minority interest in the

majority-owned corporation. Santa Fe went from 60% to 95% control of Kirby Lumber over 30+ years, and wanted to use a short-form merger to get the rest. Kirby was a closely-held corporation, but that doesn’t matter—10b–5 applies to all securities.o Delaware allows ‘short-form’ mergers, in which a vast majority can merge without

shareholder approval. Minority shareholders still have a right to fair treatment.o Ps tried to claim that low valuation of stock was an actionable fraud under 10b-5

Was the merger valid? Or unlawful under the federal securities laws? It was lawful, there were no disclosure issueso 10b-5 is a disclosure, fraud provision, does not deal with fiduciary duties

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Fed securities laws tailored for disclosure, not internal corp mismanagemento Using short-form mergers to push out minority shareholders is not “manipulation” within

the meaning of 10b-5. Term refers to practices, such as wash sales, matched orders, or rigged prices, intended to mislead investors by artificially affecting market activity. Not things allowed by state law

o Some deference to state corp law traditions - Corps are creatures of state law, investors invest w/ understanding that, except where federal law expressly requires certain responsibilities of directors with respect to stockholders, state law will govern the internal affairs of a corporation

General concern with extending the federal cause of action:o Private cause of action should not be implied when unnecessary to ensure the fulfillment of

Congress’ purposes.o Shouldn’t be implied when the cause of action is one traditionally relegated to state law.

2 possible state law remedies – but very much state law claims! Sue for “appraisal”- allows courts to evaluate value of shares being given up and

award price court thinks is appropriate Attack fundamental validity of transaction

o Claim that there’s no business purpose other than to freeze out minorityo Claim transaction is not essentially fair to them

o Difficult to distinguish between effects of short-form merger and other legal corporate moves with the same effects.

Consequences, Lessons: o If you hold stock in a Del corp, you bought into a deal that would ultimately allow an

outsider to buy up a majority of the stock on the marketplace and force you out No right to remain a s’holder of a corp in Del. But Del. Will examine fairness of terms

on which you’re forced out Other states may have corp laws reserving the right to remain a s’holder

o Reinforces the notion that public ownership of a stock is ownership of a financial asset – for legal and economic purpose, the stock is viewed as the legal right to cash flows Right is simply to get the value of that – and that right can be turned into cash

o Significantly limiting 10b-5: Unless it’s a disclosure/misdisclosure problem or issue, the claim is NOT actionable under 10b-5

9. Deutschman v. Beneficial Corp. (3 rd Cir. 1988) – Options under 10b-5 Deustchman lost money when call options, not stock, that he had purchased in reliance on the

market price created by Ds’ misstatements, became worthless. Are options considered securities for purposes of coverage of 10b-5? YES.

o Options are securities and since options have a positive role to play in the market, they are covered by 10-b(5).

o Traders in the underlying security would have standing traders in options also have standing for implied civil damages remedies under 10b-5

o A misstatement with respect to underlying company affects not only value of stock, but value of option

XXIII. Insider Trading

1. General Observations 10b-5 was created to level the securities market playing field. Insider trading exploits

unevenness… o Insider buying is NOT a private right of action

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This is another informational issue, but information of a different sort – insider rather than inaccurateo Underlying considerations - Should we not prohibit it? Do insiders deserve to benefit

from insider effort? Insider trading may drive up price of stock, make market more efficient, accurate But it contradicts underlying informational moralities and equities of our market

system Typical story – D is some sort of corporate insider, who conducts a transaction based on

undisclosed insider informationo Info can cut both ways – knowledge that prices are going up or down, decision to buy or

sello Might involve an intermediary – info might filter through someone…

Problems – does the prohibition address the problem, really protect a level playing field?o Do investors have more equal access to info than they would if insider trading was not

prohibited?o If insider trading escapes detection and punishment, and the prohibition doesn’t mean

anything people just think it does, are trading on misinformation…o BUT it’s very hard to actually get away with it. We’re very vigilant about monitoring

insider tradingo Currently, insider trading can be tracked using artificial intelligence, which is

increasingly effectiveo Less able to track developments in close corporations, or for quick trades on the market

floor Remedies – just finding a violation doesn’t necessarily address remedy – how to actually pay

this back? How do you connect the violation with the remedy?o Ds may have made an illegal profit, Ps may have been precluded from making a potential

profit, but how can you prove that? D’s transactions and P’s transactions arent connected

o Criminal penalties for individuals – Dirks, O’Hagano Government remedies – TGS, later laws

Including civil action to recover profits or impose penaltieso Very little incentive for individual private suits – take money away from insiders who

profited, but need to distribute to shareholder source of class actions2. SEC Rules and Regulations

§ 20A: Insider Tradingo This provision gives an express cause of action for damages to contemporaneous traders

against insider traders and tippers. Amount that can be recovered is limited to the amount of insider’s profit reduced by any amount disgorged by the SEC enforcement action.

§ 21(d): Insider Trading.o SEC can seek a civil penalty up to 3 times the insider’s profits.

Rule 10b-5. Employment of Manipulative and Deceptive Devices. This covers general deceptive practices.o Rule 10b5-1. Covers insider trading.o Rule 10b5-2. Misappropriation rule. Duty of trust when one gives word to, has habit of

being in confidence of, or is a relative or spouse of insider. Rule 14e-3a. Makes it unlawful for someone to use non-public information to purchase stock

in the case of a tender offer. No fiduciary relationship to shareholders is necessary.o Can’t trade on insider knowledge of tender offer

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o Even if there is no fiduciary relationship but just ‘reason to know’ that the information came from one with fiduciary duty

o If any person has taken a substantial step to commence a tender offer, it shall constitute fraud for any other person in possession of material information relating to tender offer that he has reason to know is nonpublic and which he has reason to know has been acquired directly or indirectly from: 1) the offering person; 2) the issuer; 3) any EE of issuer or offering person, to purchase or sell or cause to be purchased or sold any securities unless information has been disclosed by press release.

3. Goodwin v. Agassiz (Mass.1933) – Inside Information, but at common law, pre-SEA Ds knew about a theory of possible mineral deposits in Cliff Mining Co. land, but they didn’t

reveal it when they bought stock, through the market, from P. P claims holding info w/o disclosing it was actionable.

Insider information violation? NO, not in this case…o Advancing classic common law view that there was no obligation of trust between buyer

and seller of stock, no specially created right/obligationo Directors do not have a fiduciary duty to individual stockholders.o Plaintiff, as a sophisticated trader, could not have been defrauded because he sold his

shares of his own accord, without receiving information from the defendants.o Special facts doctrine doesn’t apply b/c this isn’t a face to face transaction

If face to face, and D had info that P didn’t but should have D needed to disclose. Failure to disclose would have been constructive fraud

But lack of privity here undermined special facts doctrine Siegel : Problem w/ this. Allows insiders to pursue inside information, to make secret profits

from it. Old Rule: profit made through insider trading isn’t recoverable. In the absence of legislation,

as a matter of common law, unless there is some special duty, trades/profits are protected. 4. SEC v. Texas Gulf Sulphur Co. (2 nd Cir. 1969) – Insider trading under SEA

TGS came across a great ore deposit and tried to keep the information under wraps, so that they could buy up the rights in the area without exciting too much interest. Go so far as to issue press release stating rumors without factual basis.

Could insiders take advantage of info that was for corporate purposes? NO. Must they disclose the info or abstain from trading on it? YES.o Rule 10-b(5)(c), “to engage in any act, practice, or course of business which operates or

would operate as a fraud or deceit upon any person” is interpreted as covering insider trading

o The info was materialo Company does not have to be a party in transaction in order to violate 10-b(5) – if it

makes a misrepresentation, even one that it doesn’t profit from, that is connected to P’s trading, corp is still liable. “in connection with purchase or sale of any security” can be a sale of P, not D Whether or not the statement was misleading must be judged based on the facts

known to Ds at the time Addressing spirit of law and congressional intent for even info playing field

General Rule: Disclose or abstain, Trading on the exchange based on material inside information violates 10b-5o 10b-5 doesn’t mandate affirmative disclosure, but does impose negative mandate that if

they aren’t going to disclose, they’re prohibited from buying and selling or giving outsiders confidential information

o NOT holding that insiders have general obligation to disclose – just can’t trade without disclosure

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o Essence of 10b-5: anyone who has access, directly or indirectly, to information intended to be available only for a corporate purpose and not for personal benefit of anyone may not take advantage of such information knowing that it is unavailable to those with whom he is dealing, i.e., the investing public. Applies to outsiders as well.

Siegel : One problem with 10b-5: when we don’t have intentional misrepresentation but insider trading, does it make sense to have a private civil damages remedy that gives remedy to sellers against buyers when the sellers who sold didn’t lose their money because the buyers bought? o When we are dealing with a market transaction (not face-to-face) that isn’t an intentional

fraud, maybe 10b-5 isn’t the best way to deal with it – maybe SEC should bring an action. The law is largely unsettled as to who can sue what for what amounts.

5. Chiarella v. U.S. (U.S.1980) – Who is an insider? Printer figured out the identity of the tender offer target and bought stock and sold it at a

profit. Non-public information associated with an offer to buy rather than a sale or the target company’s performance.

Was C an insider? NO. Not an insider of the corp he traded shares of.o Two elements of 10b-5 insider trading liability:

Existence of a relationship affording access to inside information intended to be available only for a corporate purpose

Unfairness of allowing a corporate insider to take advantage of that information by trading without disclosure

o Duty to abstain from trading arises from the relationship of trust between a corporation’s shareholders and its employees. Since there was no relationship of trust between Chiarella and the shareholders, he had no duty to “disclose or abstain.” Insufficient criminal nexus…

o Didn’t test misappropriation theory – hadn’t been raised… Siegel : In order to find inside information, you have to find a flow of information from

inside the corporation. o That’s why nothing came of Martha Stewart’s charges of securities violations – at best,

you have her broker telling her that Waxel is selling his shares. No one has alleged that Waxel told him to tell her he was selling his shares.

6. Dirks v. SEC (U.S. 1983) – Tippees and Insider Trading Dirks found out about a fraud scheme, investigated, and made a good-faith effect to make the

fraud public. Friends of his traded on the basis of the information that was not yet public. As a tippee, was he liable for the insider trading?

o Question of whether disclosure of nonpublic information is an improper breach of duty depends on the purpose of the disclosure – it must be for personal benefit.

o Some tippees must assume an insider’s duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly.

o In this case, the tipper did not breach duty since there was no personal gain. Therefore, the tippee did not have a duty to disclose or abstain.

Dissent: motive of personal gain should not be a requirement for liability for insider trading. General Rule for tippees: For Rule 10b-5 purposes, a tippee assumes a fiduciary duty to the

shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.o Need to determine whether insider’s tip was a breach of insider’s fiduciary dutyo Determined according to whether insider personally will benefit, directly or indirectly,

from his disclosure. Absent some personal gain, there has been no breach to stockholders.

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Siegel : This unnecessarily complicated the analysis, shouldn’t be about impropriety of the tip but the impropriety of the trading on it…

7. U.S. v. O’Hagan (U.S. 1997) – Blatant Insider Trading, misappropriation theory After Grand Met makes tender offer from Pillsbury, Grand Met’s attorney O’Hagan starts

buying call options on Pillsbury stock, becomes single biggest s’holder Liable for insider trading? YES.

o Distinguishing Chiarella to find O’Hagan an insider liability.o Applied “misappropriation” theory.

Liability based on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.

Breach of duty to source of insider info Difference - The classical theory targets a corporate insider’s breach of duty to

shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate “outsider” in breach of a duty owed not to a trading party, but to the source of the information.

o Full disclosure of the fact that a confidant plans to trade on the basis of the nonpublic information will foreclose liability under 10b-5, but the confidant may still be liable under breach of state law duty of loyal.

o Liability under Rule 14e-3(a) does not require a breach of duty to the tipper. Thus, even though O’Hagan escapes 10b-5 liability, he is still liable under 14e-3.

Policy: protect the integrity of the markets against abuses by outsiders who owe no duty to the corporation’s shareholders.o Misappropriation theory breaks the need for a security company tip direct chain.

Duty is not to trading party but to source of information. O’Hagan didn’t need to be a Pillsbury insider…

o Calm corrosive effect that these kinds of trades have on the public’s confidence in the market

8. Carpenter v. U.S. (U.S. 1987) Wall Street Journal’s “Heard on the Street” column had a short-lived effect on the price of the

stocks it covered. Author of column would disclose information to friends before the column was published.

Court affirmed securities fraud conviction by an evenly divided vote – thus, this decision does not have precedential value. Law is still unclear.

9. U.S. v. Chestman (2 nd Cir. 1991) Is a spouse who does not normally participate in confidential business discussions and who

has not promised to keep a secret is liable for using insider information? NO.o Laid the groundwork for O’Hagan. o Meskill finds that there’s 14e-3, but not 10b-5. o Winter’s concurrence, which became law in O’Hagan, basically. He relies heavily on

Easterbrook’s theory of information as property. o Judge Miner’s concurrence is a response to Winter’s statements about “familial

relationship.” Miner worries that it would chill basic intrafamily communications. Note that this decision has been overturned by SEC Rule 10b5-2, which prevents spouses

from using inside information.10. SEC v. Adler (11 th Cir. 1998) – Nature of the inside info, connection to trade

General Rule: insider trade must be made on the basis of the nonpublic information. If the insider could prove that she would have traded anyway, there would be no liability.

Note that this decision was overturned by SEC Rule 10b-1, which defines “on the basis of” as “awareness of” with only a few narrow exceptions.o Now knowledge of inside info and subsequent trading w/o disclosure probably a problem

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XXIV. Short Swing Profits

1. General Observations Short Swing Sales/Profits restricted by bright-line rule SEA §16. General Rule: Every person who owns more than 10% of stock or who is a director or officer

shall file statements with SEC within 10 days of becoming a beneficial owner (this provides documentary evidence for 10b-5 violations). Any profit realized by one of these people within 6 months shall inure to and be recoverable by the issuer, irrespective of any intention on the part of the owner, director, or officero Corp recovers profits made through short swing trades, any time the corp loses out in

totalo Only applies to corps w/ stock registered under SEA

Purpose - eliminate one source of market fraud by adopting an absolute prohibition on short-term trading by officers and major shareholders.o Harsh provision, punitive effect totally crack down on these sales

Effect – pretty clear notice that people who qualify shouldn’t trade in both directions within a 6 month period, can’t do so without facing claim for recovery of the profits earnedo Clear notice to officers, directorso Even without knowledge of inside info, can’t do it…

Note that derivative action doesn’t have to follow requirements such as security bond – it’s a federal action and goes directly to federal court.

2. SEA §16. Rule regarding short-swing transactions.

o §16(a) – every person who directly or indirectly owns a class of securities, more than a certain amount, needs to register, maintain filings about holdings and changes to holdings SEC collects information on stock trades by insiders. Disclosure of holdings by directors, officers, and beneficial owners.

o §16(b) – for the purpose of preventing the unfair use of information received through a relationship with the issuer, short swing trades/profits are prohibited Matches any sale with any purchase within the time frame.

Match stock sales and purchases in whatever way maximizes the amount the company can recover. Use the lowest priced purchases with the highest priced sales, regardless of order increase punitive elements

There is strict liability for any profit made on trades under §16(b). There is a private right of action for corporations or for shareholders derivative action. ANY profit realized by s’holder is recoverable – absolute rule that requires

corp’s recapture of profit Deputization: If a firm’s employee serves as a director of another firm, §16(b) may

apply to the first firm’s trades in the stock of the second. Bottom of §16(b) gives exemption to a beneficial owners who was not a beneficial

owner at the time of either the sale or the purchase. On the other hand, officers and directors are liable if they were officers or directors at either sale or purchase.

§16(b). Profits from purchase and sale, or sale and purchase within 6 months must inure to issuer (corporation). Exception for beneficial owners who are not beneficial owners at time of both purchase and sale.

o §16(c) explicitly deals with “short” sales. They are absolutely prohibited. Short sales: you borrow stock that you don’t own and sell it assuming the price is

going to go down. You buy it back at the lower price and then repay it in kind.

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Siegel : Officers and directors are subject to § 16(b) liability if they occupy that position either at the time of purchase or at the time of sale. The brightline 6 month mark both penalizes insiders for trades unrelated to nonpublic information and misses many trades based squarely on such information.

3. Reliance Electric Co. v. Emerson Electric Co. (U.S.1972) – At time of sale, Step transactions An owner who held 13.2% of stock in corporation sold twice within 6 months, but the first

sale got him down to 9.96% ownership. Stepped down below 10% threshold after first sale. Is he liable for profits of 2nd sale? NO. Even though step transaction was designed to avoid

16(b) liability, it’s allowedo Beneficial owner was not a beneficial owner at the time of the second sale.

S’holder must own more than 10% of class of stock both at the time of purchase and sale to be held liable by corporation under § 16(b).o Underlying reasoning – read 16(b), such a punitive provision, narrowly…

Consequence - §16(b) has relatively little power over beneficial owners, who can structure transactions to avoid it, though it still affects officers and directors, who only need to pass threshold on one element of the transaction.

4. Foremost-McKesson, Inc. v. Provident Securities Company (U.S.1967) – At time of purchase A person owned 0% of stock and then purchased so much that he owned 15% of stock. Is S’holder covered by 16(b)? What does “at the time of the purchase” mean?

o Need a preexisting condition of sufficient ownership.o Purchase that created passed the threshold doesn’t trigger 16(b). All transactions after

that do.o This is only the rule for beneficial owners, NOT for directors/officers

General Rule: Must own 10% or more before the first questioned transaction, must already be above the threshold.

5. Kern County Land Co. v. Occidental Petroleum Corp. (U.S. 1973) – Stock Swap Is it a § 16(b) “sale” when the target of a tender offer defends itself by merging into a 3 rd

company and the tender offeror then exchanges his stock for the stock of the surviving company and also grants an option to purchase the latter stock that is not exercisable within 6 months?o Does a stock swap qualifies as a §16(b) violation? NO. Mere execution of an option is

NOT a sale.o In borderline cases (but not straightforward cases) Court looks at whether the transaction

serves as a vehicle for the kind of evil that Congress intended to prevent. – look to spirit of law Don’t apply a technical, mechanistic approach

o In this case, the defendant would not have had access to insider information, which was the kind of evil Congress intended to prevent. So, while there may be cases where a stock swap will result in §16(b) liability, this is not one of them.

Underlying concerns – 16(b) is a dangerous rule, courts should read it narrowlyo Rely on spirit of provision expressed in preface, just trying to prevent unfair use of info

XXV. Control in Publicly-Held Corporations – General Observations

1. Applicable Laws – Both Federal and State SEA – provisions to control internal corporate organization and operations

o Disclosure to shareholders in a sense, concerning corp’s actions re: election of board of directors, mergers, dissolution, other proposals that must be voted on by the shareholders

o Recognizing that delegation to corp board is not complete, securing periodic intervention by shareholder

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o Still disclosure based to some degree – what is required to be disclosed before, during shareholder meetings, etc

State Law – traditionally controlled internal corporation lawo Has always required annual meetings, regulates board elections and shareholder approval

provisions Basic board election details – notice of an annual or special meeting, details of

meeting in advance, details of voting Purpose – preventing board from pulling a fast one on s’holders by sneaking

something unexpected into the meetings Major corp changes may require specialized notice to s’holders Limiting ability of board to act and make changes w/o notice to s’holders

o Less developed state law re: proxies – federal law preempted developing proxy issues Some basic disclosure provisions – misdisclosure will give rise to state law fraud

remedy Can typically stop voting under state law – immediately bring an action if there’s a

suspicion that disclosure isn’t accurate, TRO against voteo Example: NY §608 – requires both notice and quorum

Notice of annual or special meetings, provision for warning about business to be carried out at each, with general “and any other business” statement

Quorum – typically majority of voting shares, though certain issues may require more than that Physical presence by majority not typically required

2. Shareholder Voting Shareholder election of boards really only fits cases where there are a hundred or so

shareholders. o Too few elections usually redundanto Too many collective action problems

Voting in publicly held corps:o Usually follows straight voting process

Each shareholder votes up or down for each candidate. Majority can elect all of the board positions.

o Elections decided by a plurality – highest votes win, even if not a minorityo Electing general directorships – people run for position as director, not for a specific

director Voting in practice: Corporate realities speak to the power of the current management,

incumbentso 99%+ US publicly traded corps, number of candidates for spaces on the board is exactly

equal to the number of candidates 5 slots, 5 candidates offered by current board

o Nomination process is absolutely crucial why proxy options so important Typically controlled by leading insiders

If actual members of board don’t have majority of shares, how do they keep themselves in office?

Control comes from existing control, not voting power Exceptions – some outside directors are powerful, takeover events

o Actual s’holder vote more like a ratification of board’s slate, though s’holders can run and vote for their own slate point of a proxy contest

o Alternatives – open elections Some current movement for opening up corp elections more – some consideration of

rules allowing or mandating other/outside nominations on the proxy statements

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At annual or special meetings, votes include:o Electing Board (essentially universal that elections are unopposed)o Major corporate changes (amendment of articles/bylaws, merger, dissolution, sale of all

assets)o Ratify certain transactions (e.g., interested directors’ transactions, stock option plans)o Ratify selection of auditorso Proposals put forward by corporation or shareholders.o S’holders NEVER vote to approve actions of board of directors taken over prior year,

distribution of dividends

XXVI. Proxy Fights

1. General Observations Proxy voting – effectively an absentee ballot system, universal way to deal w/shareholder

presence/absence:o S’holder can’t vote by mail, designates a proxy.

Though proxy inherently revocable until moment vote takes place facilitates s’holder’s ability to participate and vote, keep rules flexible for them

Only the actual shareholders get to vote – street name holders just pass through proxies

o Proxy MUST attend meeting, and MUST vote as directed by s’holder. If proxy doesn’t, we act like he did total legal fiction

o Important, though, because representatives of a majority of shares must be present for quorum at meeting. Valid s’holder meeting requires notice and presence in person or by proxy of a

quorum of the shareholders (a majority in number of the voting shares). o When a company is registered under § 12(g), then § 14, the federal proxy rule, applies. o Major issues concerning proxy voting:

Who bears the expense of the proxy process What happens when the proxy contains misinformation How does the proxy process occur, what must be on the proxy… What must be disclosed on the proxy

SEC requires (and reviews, though not as rigorously as initial filings) 3 sets of documents from corporation concerning proxies:o Form of proxy – actual right to voteo Proxy statement – description of issues to be covered at meeting

Example: HP Date, time, place of meeting Explanation of document and meeting Invites s’holders to nominate candidates – they’re ahead of the curve on this,

assuming SEC is going in this directiono Most corps don’t encourage this…

Description of board members, board positions and director compensationo Compensation includes option grants – questions raised in Seinfeld

Slate of candidates – despite solicitation for suggestion, management offers 9 candiates for 9 slotso All info disclosed about candidates is filed, becomes fully public

Ratification of accounting firm choice and audit Approval of additional 75 million shares for employee stock purchase plan

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o Annual report – overall description of company’s business Proxy Fights:

o Designed to oust the current management – when corp isn’t doing well, s’holders may put together their own slate of board candidates

o SEA allows proxy fight. S’holders alert corp, which can provide shareholder list or mail s’holders challenge directly/cover their costs.

o How can challengers get access to s’holders to inform them of their slate/position? Need access to s’holder registry State law may allow/require it SEA §14 gives corp 2 options – provide list, provide mailing services

Corp would rather mail for you, not give up list – more control for themo Problems – Extreme expense

Can cost well over a million dollars: you need to make contact with shareholders, mail each person documents with return postage at least twice, and you need to file with the SEC

Who bears the expenses? How are things worked out?o Alternative – buy up control of the corp (better alternative now)

Rather than voting out the management, better to use cost of proxy battle to buy up control of the corp, gain a big voice, and change management from the inside

Underlying concerns of §14 implied action cases:o Acting on underlying principles of the securities regulatory schemeo Court is creating the law through the implied remedy to further what they think is the

purpose of the lawo Congress or the SEC could always step in and change things though…

2. SEA §14. Grants the SEC authority to regulate proxy statements.

o 14(a) – outlaws anything in violation of the statute Shall be unlawful to act in contravention of such rules and regulations proscribed by

the SEC concerning the solicitation or use of proxies concerning registered securities Can’t solicit or permit to be solicited proxies in violation of the rules… Basis for the implied private civil damage remedy, like the implied private cause of

action from §10bo 14(b) – SEC’s preconditions for proxy use - mandates that before proxies can be used, a

lot of information needs to be given to the shareholders Can’t solicit proxies without supplying an annual report (10-K) The actual proxy statement - Need to send out documents that are specific to the

meeting – details where the meeting will be held, what will be done, more info about the meeting, people proposed to be elected to the board (in detail)

Form of proxy – probably some sort of punch card, the actual form you sign acknowledging that you’ve given your proxy and how your shares should be voted Can’t be undated, practical details MUST be furnished Proxy voting can NOT be default – need an affirmative signature

o Not allowed to say that “unless you sign the card, the company will be your proxy”

o Though corp can set up and provide notice of default voting choices – if proxy is signed but boxes aren’t checked presume to vote with the board…

Because these forms are the subject of detailed regulations, their form and content are explicitly laid out in the federal regulations all reviewed by SEC

o Proxy disclosure documents potential liability on 3 levels

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Criminal – criminal prosecution Adminstrative – SEC can stop annual meeting Civil damages – implied from act, can be used to stop meeting

3. SEC Rules and Regulations Rules 14a-(2-5,11). Regulates proxy solicitations.

o 14a-2. Shareholder who does not solicit proxies does not have to register with the SEC.o 14a-(3-6). People who solicit proxies must furnish each shareholder with a “proxy

statement.” Must file copies of statement with SEC. Rule 14a-7. Gives management the choice of supplying shareholder list or sending out

materials at cost in proxy fights. Rule 14a-9. Makes it unlawful to send false or misleading proxy statements. Implied private

right of action comes specifically from this.4. Levin v. Metro-Goldwyn-Mayer, Inc. (SDNY 1967) – Strategic Use of Proxies, Proxy

Expenses Can management use corp money to pay expenses of running campaign for proxy candidates?

YES. If the contest is one over policy, rather than over pure control and personality, and if the expenditures themselves are calculated to inform the shareholders, to advise, then those expenditures are going to be approved.o Corp has an obligation to convey info about candidates to s’holderso Court divides issue into 2 questions

Is it legitimate for management to pick up proxy expenses at all? Yes if policy not personal… Problem – rare that court will look through corp’s arguments to find a personal

conflict, corp can always present some colorable policy claim Is it legit to pick up these expenses? Yes…

Public relations firms may be employed as part of the process of soliciting proxy votes.

Professional proxy solicitation prob covered – might be most cost-effective way to do it anywayo Able to get to real s’holders, through street name holders, can work

independently Special expenses – flying major s’holders in for special campaigning – prob more

suspect General Rule: contest is over policy and not just ‘personality’ corp can pay.

o Generalized propriety of these expenses – informing s’holders of the issues is appropriateo Expenses have to be covered, reimbursable in order to make proxy challenge practicable

Siegel : Rule weighs the contest heavily in favor of the incumbentso Underlying implications – we know these are real policy contests, and that expenses may

be propero But want to encourage board transition through buy-up/takeover rather than proxy battle

Acquisition is less expensive, provides more guaranteed control, at least some voiceo Conclusions – that proxy battle is a policy issue is almost a given, courts tend to not look

into nature of expense Most battles now over disclosure, information on proxy materials

5. Rosenfeld v. Fairchild Engine & Airplane Corp. (NY 1955) - Reimbursement of Costs After the outsiders win the proxy contest, the new board votes to reimburse both the old

board’s expenses and their own expenses and get that second vote ratified by the shareholders Can board make expenditures to recover proxy costs? YES.

o Directors must be able to make expenditures for soliciting proxies or the ability of the corporation to achieve quorum and thus be managed effectively would be impaired.

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o Test is whether or not directors act in good faith in a contest over policy and whether expenses are reasonable.

o Demonstrates that both outsiders and insiders are under powerful incentive to spend as much money as quickly as possible. The votes are ‘all-or-nothing’ for each side. Shareholders implicitly support original outsiders – did vote them in

Dissent: says that ultra vires, i.e., unreasonable, expenditures must be ratified by unanimous vote of shareholders.o Dissent also notes impracticality of policy versus personality test.

6. J.I. Case Co. v. Borak (U.S. 1964) - Private Actions for Proxy Rule Violations Proxy solicitation in connection with a merger issued with misleading/defective information.

S’holder brings action against corporation alleging that merger would not have been approved but for false and misleading proxy statement.

Is there a private right of action for false and misleading proxy statements in violation of § 14(a)? YES. The purpose of § 14(a) is to prevent management and others from obtaining authorization for corporate action by means of deceptive or inadequate disclosure in proxy solicitation both direct and derivative causes of action.o Shareholders may file derivative suits since the damage to come out of uninformed votes

is to the corporation directly.o Private enforcement of the proxy rules provides a necessary supplement to Commission

actiono Allowing private action is the only way to truly effectuate the objectives of §14

What is the appropriate relief/remedy? Whatever’s appropriateo Could be damageso Could be injunctive relief

Siegel : Consequences – made civil action default response to corporate matterso Any time s’holders want to block something, can read proxy material closely and try to

find something that supports some §14 claim. We’re too willing to presume material misstatement

o Temporarily blocking the deal should be enough to kill it. S’holders may be trying to test entire fairness of transactions, but may also over-use the option

7. Mills v. Electric Auto-Lite Co. (U.S. 1970) – Causation, Proxy as an essential link Corp A is parent of corp B; corp A proposed merger into corp B but corp B proxy materials

failed to disclose that corp B board was nominated by corp A; since the omission was material to P as a corp B shareholder, P sues…

What causal relationship must be shown between misleading proxy statement and merger? None,o Proving ‘causality’ (i.e., that a misstatement affected a vote) is not necessary if one has

proved materiality, and if, as here, he proves that the proxy solicitation itself, rather than the particular defect in the solicitation materials, was an essential link in the accomplishment of the transaction. Proving causal link would be so difficult it would foreclose the action

o Apply an objective rather than psychological testo Liability under §14(a) cannot be foreclosed by a finding that the transaction (e.g., merger

or interested director transaction) was fair. Would bypass the voter as shareholder. Relief can be affected by entire fairness of merger.

General Rule: If proxy was essential to ultimate transaction, and proxy contained material misstatement proves causality sufficiency.

Possible forms of relief:

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o Setting aside merger or other equitable relief, but does not require court to “unscramble a corporate transaction merely because a violation occurred.”

o Would setting aside the merger be in the best interests of the shareholders as a whole? Only undo it if it would be equitable to do so.

o Monetary relief might be afforded to the shareholders only if the merger resulted in a reduction of the earnings or earnings potential of their holdings

o Might also include attorneys feels - A petitioner who has established a violation of the securities laws by its corporation and its officials should be reimbursed by the corporation or its survivor for the costs of establishing the violation. Making the corporation pay the attorney’s fees spreads costs among the shareholders benefited by the suit

Consequences – corps can fulfill formalities of disclosure and avoid being challenged on the transaction, as long as disclosure and voting occurs issues shift back to state law entire fairness evaluationo Eliminates the §14 claimo Though courts will address spirit of the law, underlying equities

8. Seinfeld v. Bartz (N.D. Cal. 2002) – Disclosure of Option Values When Ds don’t include value of option grants in proxy statement soliciting vote on

amendment to director compensation, Ps accuse them of negligently violating § 14(a). Does corp have to calculate option values for options given to executives in proxy materials?

Did failure to do so violate §14? NO.o Follows NY and Del state law precedent Black-Shoals is not material as a matter of

lawo Omission was not material not actionableo Test used: P doesn’t have to demonstrate that disclosure of the fact in question would

have caused a reasonable shareholder to change his vote; instead, it is sufficient to establish a substantial likelihood that “under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of a reasonable shareholder.”

Consequences – NOT good law any moreo Intentional absence of agreement on this issue in advance of caseo It’s now standard industry practice, adopted accounting standards regulation that options

must be valued in proxy materialso No requiring specific valuation – but most people use black shoals

General Lesson: Materiality, even in a post-TSC world, is also dependent on the regulatory structure that the SEC has in place at any given moment. Need to consider what the SEC considers important, reliable, etc.

XXVII. Shareholder Proposals

1. General Observations Major form of corporate democracy – giving s’holders access to management’s proxy

statements for their own ideaso Purpose – want to provide an opportunity for participation by s’holders in m’ment’s

proxy efforts HUGE step from basic disclosure provisions

Practical details – s’holder proposal option is highly regulatedo Proposal limited to 500 wordso Limited in subject matter – can’t propose things beyond business of the corp

Can’t make political statements Can’t make proposals about day to day operations of company

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o Default for proposals is inclusion – Corp has to bear burden of proving why it should be excluded

Extent of the right to include a proposal:o Key issue for inclusion seems to be phrasing – need to present a case that is

Not an ordinary business matter Focused on an issue of policy Focused on something that affects the corp’s business in a significant way That isn’t an issue of public welfare – need to affect corp directly

When can a company exclude a proposal? Number of reasons, including:o Even if you are eligible, meet all formality requirements, corp can submit one of these

reasons to SEC and exclude proposal: Iimproper under state law Violation of law Violation of proxy rules (materially misleading information); Personal grievance or special interest (it is designed to result in a benefit to you

which is not shared by other shareholders); Relevance (5% rule); If company lacks the power or authority to implement the proposal; If proposal deals with a matter relating to the company’s ordinary business

operations. o When a company wants to exclude a proposal, it asks the SEC for a “no action” letter.

Shareholder must then bring an appeal of an administrative finding under the APA. Whether or not it is granted, the no-action letter becomes the basis for appeal from admin proceedings to fed dist ct.

o Siegel : Last 2 work together to say, if it’s too big, we can’t do it; if it’s too small, it’s an ordinary business matter that is completely within our power.

Siegel : corporate opposition to shareholder petitions is sociological – the in-group thinks that dissent will make their whole structure fall down.o But many standard practices developed through repeated efforts at s’holder proposals o After repeated pressure by s’holders, corps caved b/c easier for them to adopt practices

than continue to fight issues2. SEC Rule - Rule 14a-8. Gives shareholders the right to create resolutions or proxy statements.

14a8-i. Lists reasons that company may exclude proposal:o (1-2) Improper under state law or violation of law.o (4) Personal grievance or special interest.o (5) Relevance. Proposal relates to operations accounting for less than 5% of company’s

total assets or net earnings and gross sales, or otherwise not significantly related to company’s business.

o (6) Company lacks power or authority to implement proposal.3. Lovenheim v. Iroquois Brands, Ltd. (D.D.C.1985) – Shareholder Proposal

S’holder tried to get a proposal about pate de foie gras and animal cruelty onto proxy materials.

Should the proposal be included or was it excluded under Rule 14a-8(i)(5)? Rule 14a-8(i)(5) ferrets out proposals related to under 5% of revenue or not otherwise

significantly related to business? Included.o Depends upon definition of “significantly related”

Rule 14a–8(c)(5) allows a company to omit from a proxy any proposal that deals with <5% of a company’s assets/earnings, and is “not otherwise significantly related to the issuer’s business.”

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o Economic interests are not the only considerations to be judged under 14a-8(i)(5). If the proposal raises policy question important enough to have a significant relationship to the issuer’s business, it may not have to reach the economic thresholds. the concerns raised by the issue WERE significantly related to make the proposal in the corporate interest

4. NYC Employee’s Retirement System v. Dole Food Company, Inc. (SDNY 1992) – Ordinary business exemption NYCERS wanted Dole to weigh in on the national debate over health insurance by

establishing committee to research the impact of different health insurance plans on its business. Wanted to propose committee.o Dole raised “ordinary business” exemptiono But SEC had said that the purpose of the prohibition was to weed out proposals that did

not contain a substantial policy or other decision. Include the proposal? YES. This was not an ordinary business matter.

o Proposals that involve “ordinary business matters” that are mundane in nature and do not involve any substantial policy or other considerations, may be omitted

o Reality – good lawyering. Not arguing that Dole should put policies inot effect, but should just put a committee in place to study potential policies Can be fully implemented Looks more tied to actual corp operations

General Lesson: Company-wide strategy proposals aren’t covered by ordinary business prohibition.

Siegel : Quetionable result – forces the corp to do unrelated things – could have raised a “out of our line of business” defense… Should have turned general healthcare issue into more particular one for the company. This is a total policy matter, too far from basic disclosure focus of fed securities laws

5. Austin v. ConEd of New York (SDNY 1992) – Personal matters exemption Shareholders attached to local union wanted to include a non-binding resolution endorsing

the idea that employees should be able to retire after 30 years of service, regardless of age. Mandatory inclusion of proposal or is exclusion allowed? Exclusion was allowed.

o Resolution concerned an “ordinary business matter” - Dealt with specific pension plan, too specific to not be an ordinary matter Relied on fact that SEC has long record of issuing “no action” letters in similar cases

is relevant because they were ordinary matterso Also primarily for personal benefit of s’holders raising it…

Relied on Dow Chemical napalm caseo S’holder wanted proposal about getting Dow out of the napalm businesso Dow challenged that such a proposal was either day to day business of no consequence,

small portion of the business, or general policy issues that can’t be implemented…o Court ordered proposal inclusion - the costs of not including the proposal, of maintaining

the napalm business are so great. Given overall costs (social and commercial), Dow must include Nationwide boycott of dow products, repeated protests at dow facilities, etc Ultimately vacated as moot because Dow had pulled out of the business before the

case was resolved

XXVIII. Shareholder Inspection Rights

1. General Observations

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Federal component under 14a-7 is that corporation must either mail materials on proxy campaign at cost or give the shareholder list.o Most will choose to mail themselves and keep list confidentialo BUT well-counseled insurgent will be unwilling to rely on the management – information

about the shareholder may be crucial in a battle for control, and the insurgent will want to identify holders of large blocks of stock and spend his efforts trying to convince the major stockholders to support him. He will want the shareholder list Can demand list if state law permits – no fed law requiring it

State law generally requires corporation to hand over list of shareholders and other corporate information if this information is to be used for a “proper purpose.”o Ex: NY §624 – totally clear that s’holders have access, though ambiguous about what

they have access to Inspection rights of the proceedings of shareholders Inspection rights of the list of shareholders - Corporation must maintain a list of

shareholders Standards for reviewing requests

Access for any purpose reasonably related to their interest in the company, for purposes reasonably related to their investment, etc

Can’t ask for purposes that are totally unrelated to business of the corp Forum law applies to foreign corporations - specific provision applying NY

inspection law to foreign corporations doing business in NY Reversing incorporation state law presumption Why? Because of NY interests – NYSE, most major public corporations, those

relevant to being subjected to the inspection right, will now also be subjected to NY law

o CA §1315 – shareholder of record of a corporation doing business in the state can require the corporation to produce a record of its shareholders Also applies forum law to foreign corps – has been tested not constitutionally

prohibited from doing so Related state law issue – application of law of the forum, rather than law of state of

incorporation o Why does inspection right create appropriate conflicts of law question? o There is clear forum shopping on corp’s point – chose state of incorporationo Allow s’holder to even playing field a bit on the access infoo State’s own interests – if corp is doing business in a state (to get it into the forum in the

first place), state has interest in insuring that it follows some of its own rules Practical concerns - Actual access to what? What sort of records? How far into corp’s

documents does this right extend?o What’s the appropriate standard of review? On what grounds should an inspection right

be judged…o For a proper purpose – whatever that means…o What do you get – whatever the corp gives you, but basically name of s’holder, number

of shares held, address info on file General Rules of Inspection: the key components in most states is that the right is conditioned

ono Party being a stockholdero Demand being for a proper purpose. o Most state statutes provide access to financial statements (if they are prepared), minutes

of shareholders’ meetings, minutes of board of directors’ meetings.

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These are the “tools at hand” – requirement to show a proper purpose takes on more force in this type of situation

2. Crane Co. v. Anaconda Co. (N.Y.1976) – Proper Purpose Shareholder Crane is trying to get a copy of Anaconda’s shareholders list in order to inform

them of its exchange offer and to solicit tenders of stock Does crane have a right to inspect the lists? Should he have access? YES. shareholder

desiring to discuss relevant aspects of a tender offer should be granted access to the shareholder list unless it is sought for a purpose inimical to the corporation or its stockholderso Rely on NY statute: any resident of the state who is a shareholder of a foreign

corporation may require it to produce a record of its shareholders. Consequence – opens up s’holder list to fairly public scrutiny just because of tender offer

o Other states may have stronger precautions for giving up their lists – try to filter the info before giving it up…

o And getting the list doesn’t mean it’s usable – corp is not going to make it “easy” to use…

o Open question – can corp voluntarily make list available for other things? Or is that some sort of privacy violation?

General Rule: Provide access to s’holders for reasonable purpose when demanded by state law

3. State ex rel. Pillsbury v. Honeywell, Inc. (Minn.1971) – Proper Purpose Shareholder bought shares to protest company’s role in manufacturing weapons. Wanted

shareholders’ ledger and corporate records dealing with weapons and munitions manufacturing in order to contact other s’holders to argue for changes in Honeywell’s Vietnam policy

Is this a proper purpose for demanding inspection? NO. It’s not germane to s’holders “real” interest in the corpo NOT within the inspection right to get records having to due with the substantive

business of the corporationo “Proper purpose” contemplates concern with investment return o Efficiency arguments – letting thousands of shareholders to roam at will through

corporate records would make it impossible for corporations to carry out their businesso power to inspect may be the power to destroy; it is important that only those with a bona

fide interest in the corporation enjoy that powero Combined with initially questionable reasons for buying stock – just to get a foot in the

door for this…o Buying stock only for the sake of instituting proceedings or investigating a corporation is

an improper reason to have right to inspect. Neither inspection nor investment were for a proper purpose

General Rule: Proper Purpose for inspection typically related to investment and financial interests in the corp. Helps limit access generally to published, audited, prepared financial statements and access to normal shareholder proceedings.

Underlying issues – this was a show case, argued in the extremeso Clearly never going to get all this – NO absolute right of inspectiono Wanting to lose for politically symbolic purposes – access prob wasn’t even the point

4. Sadler v. NCR Corporation (2 nd Cir. 1991) AT&T used NY shareholders the Sadlers to try to obtain MD corporation NCR’s NOBO list

(beneficial owners of shares who do not object to disclosure of their names), which NCR hadn’t even created yet. AT&T couldn’t act directly because it hadn’t owned stock for long enough.

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o Under NYBCL §1315 - part of inspection right given to shareholders is the right to obtain the NOBO list, even if the NOBO list is something not in possession of the corporation.

Does corp have to turn over a NOBO list, which it doesn’t have but can compile? YES. Under NY law…o Underlying purpose – if s’holder can’t get access to the list, ability to wage proxy fight is

severely limited Helps to go through the anonymously maintained CEDE list, and contact the

shareholders who don’t mind having their identities disclosed to make their point directly

Better than having to go through the brokerage houses or the corporation itself Trying to give the objecting shareholder an even playing field

Note: Del corp tried under New York corporate law. Ct concludes this is proper, constitutional exercise of state power.o Internal affairs governance presumption does NOT apply to inspection rights if state has

legislated that way General Bottom Line: Since there’s always going to be a NY shareholder, always some way

to bring action in NY, there will always be full access to the shareholder list and NOBO list in a proxy contest.

XXIX. Shareholder Voting Control

1. General Observations What does s’holder voting really mean?

o Concerns of shareholder control – in the form of controlling the board of directorso Targeting concerns about our model of the corporation – want to assure some s’holder

participation Controlled by the board of directors Created to deal with the problems of varied, dispersed, passive investors/shareholders Shareholders only need to come together to vote for the board Can then delegate all control to the board…

o Different in both degree and kind from the closely held corporation – corporate structure but one in which all or most of the investors are active participants in the business. Fewer s’holders, ownership interests in small group, small number of blocks

What’s the connection between shareholding and voting control? What if shareholders want equal control but are not contributing equal amounts of capital?

Disaggregate shareholder rights - can divide the control differently from how you divide the equity interests.o Ex: if A contributes $1M and B just contributes name and they divide up shares equally.

If B tries to dissolve company – proceeds of sale of assets upon dissolution are divided in proportion to the number of shares of common stock that they own equally despite totally unequal contribution Would shift lots of money to B. So give them each 25 voting shares, but give A 375 nonvoting shares and give B 75

nonvoting shares – equal voting control, not equal actual interest.o Difference between partnership and corporation

3 interests in a partnership: 1) voting; 2) profit/losses; 3) capital/assets Partnership vote inheres in the person, and the presumption is one person, one

vote, division of profits and losses equally

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For corporations, each share has the same 3 interests, and the presumption is that the fractional interest in each of the 3 separate characteristics is identical (number of shares you own / number of outstanding shares) WHAT DOES THIS MEAN???

Problem: Disaggregated shares are inherently unequal in valueo Voting shares are ALWYS more than nonvoting shares

Courts are now accepting of many voting arrangements: o Contingent voting share - a share of stock might vote in certain circumstances but usually

doesn’to Preferred stock - no vote but first to get dividendo A share that is nonvoting for board of directors but voting for merger. o Also can have 3 types of common stock which are identical except that A is entitled to

elect A director, B is entitled to elect B director, etc. Problem: not used very often because it’s so inflexible. Ex: A dies and leaves shares to 2 sons; if 2 sons can’t agree, we have a deadlock as

to who should be elected as A director But not accepting of certain corp actions – Corps can NOT selectively contact s’holders in

order to campaign for voteso Can’t distribut info selectively, under fed lawo Proxy regulations mandate that if the corp is seeking a shareholder vote, distributing info,

it has to make the information available to all shareholders May be able to be extremely selective – contact one s’holder for a nonpublic

transaction that s’holder has particular interest in, but not a general thing…2. Stroh v. Blackhawk Holding Corp. (Ill. 1971) – Disaggregated shares

Corporation creates a class of stock that has voting rights but no rights to profits or capital. Is this allowed? YES. Allowed at time, under state constitution. Has since been changed

o Court says that parties may divide of rights to voting, interest, and assets by defining shares however they want within the confines of the 1870 voting requirement.

3. State of Wisconsin Investment Board v. Peerless Systems Corp. (Del. 2000) Board maneuvers to prevent a vote averse to its interests from passing. Adjourns meeting

saying that there weren’t enough votes, but then votes at the next meeting with little advertising and not many more voters.

Is this allowable voting/election conduct? NO. Blasius standard: Where the primary purpose of the board’s action is to interfere with or

impede exercise of the shareholder vote and the stockholders are not given a full and fair opportunity to vote, the board must have a compelling justification for its action. o Plaintiff must prove primary purpose of board was to thwart shareholder vote.o If plaintiff succeeds, defendant board must demonstrate a compelling justification for its

actions Underlying issues – what do we mean by shareholder voting control?

XXX. Control in Closely-Held Corporations

1. General Observations Bulk of US corps are smaller, closely held corps w/ fewer shareholders…

o Major asset of American corporate systemo Open access to incorporation, easy ability to work through the corporate form is

extremely importanto Recognize differences between public and close corps

Migration from small to large corporations, and the reverse, is a change in form as well as substance

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Difference in corp form is extremely substantial Public corp now seen as default – corps can elect shareholder control, close corp

status Add provisions into articles of inc to change default board control provisions

Closely held corporations effectively reflect a change in the mechanisms of shareholder control Active participation rather than delegation to the board

Closely Held Corporation Law – Openly contractarian, trying to structure a business by private orderingo Now operates in connection w/ major corp law – new thing, used to be a a conflict

between prescriptive rules of corporate law and the rules of private orderingo Now may have different rules – don’t necessarily put these corps through the same

requirements Even if a close corporation does not choose to opt in, it might still benefit from the

legal standards applied to closed corporations.o Tied to partnership law – also about private ordering, where management structure is set

up by the parties Open-ended, flexible, not necessarily linear management structures Same outlook but built on a different legal foundation, in a different legal framework

Lawyering Problem - how to privately order the management of a closed corporation. How to build the corp from the ground up to advance the objectives of the s’holders.o What do the participants want?o How can that be implemented through the agreements?o Especially re: voting and related issues – Why couldn’t you do this in the past? Why can

you now? Not just whether you can write the agreement, but can you enforce it? How? For how long? Agreements carry risks – developed in context of long term working relationship Structures need to satisfy test of continuous fairness to parties, must be capable of

dealing with unanticipated issues Need to consider contingencies in advance

2. Shareholder Voting Issues – one main reason to maintain close status is to have more control over voting rights How can voting rights be tailored to a particular corporate setting? Many options

o Ex: NY law – all rules can be changed. Plurality typically enough for ordinary business matters, but articles/bylaws can specify Votes can be contingent on outside developments, special rules for specific issues Example – amendments to articles of inc will not be allowed with only a plurality,

will always need at least a majority if not more NY §801

It may be that shareholders intend that the division of control is different from the division of ownership interests. Ways to guarantee results of elections to board of directors. There are numerous devices for doing this: (general concern – if you’re taking a contractarian approach, MUST be clear on things up front, try to consider all contingencies)o Stock differences – A stock votes for A director…o Voting agreements – requiring higher percentages for certain decisions, unanimity

provisions Every state allows them Particularly good for rules that corp really needs to protect, keep in play Risks – veto power – very few board members can prevent the whole plan, destroys

flexibility of company, prevents easy corp reaction to developments

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o Shareholder, as opposed to director, voting agreements – take issue away from the directors, add independence, isolate decisions or ways to change from the board (the interested parties most likely to get into the dispute) Example – shareholder bylaws are only changeable by shareholders Only concerns election of directors, stops at top level of corp, doesn’t control what

directors will do once electedo Voting trusts. Old mechanism that separates ownership interest from control. Term is

statutorily limited, but a voting trust has the advantage of being essentially self-enforcing. Subject to all other trust terms Advantages: 1) essentially self-enforcing if properly drafted; 2) it’s possible to make

use of the peculiar virtues of the trust to achieve the exact result you want Disadvantages: 1) in some states, the term of the voting trust is statutorily limited; 2)

there must be title passage of the shares of trust; 3) probably more public, corp might have to disclose/reveal tdetails

o Non-voting stock – equalize voting stock to equalize voting power, but have unequal amounts of nonvoting stock to reflect actual contributions

o Cumulative voting structure where shareholders can allocate their votes to director candidates however they want Makes a HUGE math difference

o Risks – of any lock in provision/agreement – board structure as created might become a problem Director might be assured election, but director might be a problem

Once directors are on the board, inside the corp, they’re much more powerful than outside s’holders, have much stronger rights

Need to create an exit strategy as well as an election strategy Parallel partnership expulsion options – expel and pay out…

How does the board of directors actually get elected? Rules typically in articles of incorporation, though there’s a risk of article amendment to change structure…o Ex: Board w/ 3 people, director slots 1, 2, 3. Corp has 3 shareholders – A, B, C – who all

want to be on the board Each owns 300 of 900 voting shares… How many votes does each have? The number of votes a shareholder gets is the number of voting shares he has times

the number of office positions. Ex: 4 slots, 100 shares of voting stocks. If S owns 60 shares, he gets 240 votes

o Straight voting system – 300 votes for each of 3 slots, can vote up to 300 for each candidate. Majority controls board elections. Could divide 900 among 5 people, but not among 2 If A and B team up, can vote in the whole board – If they each vote 300 for A, B, D,

there’s no way C can overcome that Except in CA, presumption is straight voting unless provided otherwise

o Cumulative voting – each has 900 votes total, can vote all for one person… Number of votes need to guarantee election of one director:

o Votes > (shares X positions)/(positions + 1)o Cross that threshold and that director is guaranteed a spot on the boardo No way to have a full slate end up with more than this particular candidate…

Formula fails only fail if: Deadlock (tie among all candidates): Old board will carry over and there is a

basis for dissolution on grounds of an irretrievable deadlock.

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Not voting enough share to guarantee election to board: if s’holders try to get an extra seat by spreading your votes thinner, or if your coalition falls apart might not cross threshold on any, might require run-offs, etc

Probability to have more control over board results – make sure the board’s the right size and each s’holder can elect at least one director… Just need to assure that there’s cumulative voting and that board size is

sufficiently large so s’holder seeking representation can guarantee an electiono And that board size doesn’t change

Consequences – degree of representation depends on board size

Board members to be elected Fraction of votes needed to guarantee 1 directorBoard of 1 greater than ½Board of 2 greater than 1/3Board of 3 greater than ¼Board of 4 greater than 1/5Board of 5 greater than 1/6

o Comparison: If you had to choose between this cumulative structure and a valid, enforceable agreement between the shareholders to vote for particular directors, which would you chose? The nature of the agreement is irrelevant as long as the parties go along with it W/ a cumulative voting structure, there’s less chance of litigation

Self operating agreement Only thing that can stop a candidate is to somehow invalidate the entire voting

structure or find some other basis for preventing a candidates participation W/ an an agreement, and B and C just decide to not follow it, A’s only option is

litigation… Lose the benefits of a self-operating agreement A may get breach of contract damages, but still requires litigation But also protects against amendment process that A can’t prevent

o Can also contract to require more than a majority to amend articles of inc What do shareholders actually vote for?

o Electing board of directors, dissolution, merger, major corporate changes. Board election is most important

o NOT internal operations of corp – controlled by the board itself Example – absent specific shareholder control agreement, s’holders can’t remove

president, set compensation, enter into corp contracts, craft internal policies3. State Laws - In many states, corporations can elect closed corporation status, which is governed

by special statutory provisions. It operates the same as other corporations except that all agreements like 620 can be initiated without any approval. Still often has to be unanimous Delaware Laws.

o §141. Generally establishes the powers and procedures of Board of Directors. §141(c). Allows delegation of power to committees. §141(d). Allows corporations to create classes of directors to stagger the expiration

of their terms of office. Allows different directors to have different powers. §141(e). Allows directors to rely on employees or experts. §141(h). Gives power authority to fix compensation of directors.

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o Generally, unanimous approval by shareholders can designate a corporation a closed corporation. This carries with it the automatic power to have shareholder agreements on control, voting, dissolution, elimination of board of directors

New York Laws.o Generally, operates within the context of the rest of corporation law, no special rule for

closed corporations. sets forth specific requirements (relevant to Ramos) for agreements of this type: must be unanimous, in the articles of incorporation, shares can’t fall into the hands of someone who disagrees, shares can’t be publicly traded

o §620. Agreements as to voting. §620(a). Permits shareholders to enter into voting agreements.

An agreement between 2 or more shareholders, if in writing and signed by the parties, may provide that in exercising any voting rights, the shares held by them shall be voted as therein provided or as they may agree, or as determined in accordance with the procedure agreed on by them.

Voting agreements are specifically enforceable – don’t have to be unanimous, don’t have to be published or known to other shareholders, allows for structuring voting in several ways

§620(b). Permits a shareholder to take over powers normally allowed to board under certain conditions. If you are removing power from the board of directors, the provision has to be in

articles of incorporation, agreement has to be unanimous and if shares get transferred to anyone, that person has to have knowledge and consent to the provision

Overruling McQuade § 620(f): if shareholders wear 2 hats, then they become liable as directors – they

have a fiduciary duty of good faith and due care, must exercise business judgment. Won’t be liable personally (no lifting the corporate veil). DE: no unanimity requirement – as long as it’s in the articles of incorporation, it’s allowed If shareholders are going to limit board’s ability to manage corp, s’holders might

become liable for resulting consequences Problem - If the shareholders agreed to it, that’s great, but if they disagree they

are still going to be bound – Ultimate purpose - preservation of the fiduciary obligation in a situation where

the agreement is still in place but there’s a complaint about the way it’s being used… preserves rights of shareholders and creditors constituency

§620(h). In case of (b), transfers liability from the board to the shareholder. Effectively answers the Ringling problem – now have explicit state endorsement of

voting agreements, support for their enforceability Overall conclusion – the emergence of a way of allowing an agreement to take effect

under certain circumstances, but also to handle the risks that are associated with putting such an agreement into places Dealing with the possibility that the shareholders will inherit a managerial

obligation, a standard of care, and some liability If we’re going to write/use these agreements, what should they contain, what sort

of difficulties are involved in the planning, etc4. Ringling Bros. v. Ringling (Del.Ch.1947) – Shareholder voting agreement

Two shareholders had a voting agreement which dictated that they must agree on how to distribute their cumulative vote. If they couldn’t agree, the agreement would go to binding arbitration. One of the shareholders refused to agree and refused to abide by the arbitration decision.

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o Had a clear agreement, parties screwed up the voting process and didn’t listen to arbitrator

Was the voting agreement valid? Enforceable? YES and then NO. Confusing result, frustrates all party’s intentions.o Underlying issues:

What’s the meaning of a voting agreement? Is it valid, if entered into by some shareholders but not all? Yes Is it enforceable? Yes How is it enforceable? By disenfranchising one of the board members (the problem)

o It is okay to have a voting agreement as long as there is no monetary consideration.o Throws out the offending votes altogether rather than simply switch them and enforce the

agreement. Explanation – clear case of its era, when courts were very hesitant to recognize

validity or specific enforceability of voting agreements not explicitly validated by state law

Relying on view of corp as entity created by the state, limited by state policies rather than entity structured by s’holders according to their objectives/intentions If court had felt differently, on the fundamental level, all the elements of an

enforceable agreement were here

5. Shareholder Control Agreements: Purpose – take issues of control and ways in which they can be resolved and create a structure

that is suited to the particular corpo Major concern – setting up an inflexible structure is a huge risk

Planning for the future – MUST leave it flexible, leave sufficient exit options, plan for contingencies

o Attempt to set and preserve operation of closely held corps Preserve integrity of corp against unwanted outside s’holder interference, and

preserve corp from inside out by allowing people to leave… Evaluating Agreements:

o 1st question – what is the genesis of the agreement? Why do s’holders of a close corp believe they should enter management control Voting arrangements make sense, but why get too involved in management

Value additive – control agreements add value to their investment Underlying equities – rules of firm should be set by participants in the firm,

unless there is a public policy interest in preventing them form entering such a relationship

Not whether agreement should be valid or under what circumstanceso 2nd question – enforcement

Control of What? What are these agreements arranging?o Internal control and affairs of the corpo Management structure – core issue is naming the people who manage the business,

setting their core responsibilities Officers Duties Compensation Retirement Competence

o Control over specific areas, items, issues

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Ex: Provision restricting investments over a certain amount without 2/3 vote of shareholders, restricting loans without approval of a certain officer…

Share transfer agreements May want to write provisions that convey authority, notice of intentions, even though

they arent enforceable Will be followed until there’s a dispute Specificity does not always mean enforceability, but has benefits

Some issues may be specific enough to be enforceable or at least establish a veto power Negative limitations Corp shall not do X unless/before Y occurs…

o Financial issues and provisions Salaries and retirement issues Buy-out provisions Insurance

o Exit – everything associated with problems of exit, removal, leaving Also tied to share transfers Termination and exit provisions are always the most contested – will always come up Every lock in provision should really be matched with an exit provision Well-guaged termination payments are the best option

How to institute agreements? Where do they go? How are they actually writteno Separate shareholder levelo Employment agreements – issues to consider

Duration Number of years. Then what? Termination for cause

o By whom?o What cause?

Effect of illness, incapacity Compensation

Salary Adjustments Bonuses, stock options, etc Benefits Travel and other expenses Perqs…

Duties and status Job description Other duties Amount of time; vacation Outside activities

Competition and trade secrets Consequences of termination

Liquidated damages Duty to mitigate

Parties Mergers, etc Guarantee by majority shareholders

o Terms of stock purchase/saleso Freestanding agreements

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o Articles of incorporationo Corporate bylawso Differences? Shareholder agreements are more permanent, employment agreements can

always be abrogated/terminated by the board, even if that requires breach damage payments to the party

Share Transfer Issues, Corporate Succession:o All corps will have to deal with certain events – retirement, sale, termination, new

investment, mergero How can the corp respond?

Buy-out – by the corp or other s’holders Sale – to outside parties, or inside s’holders Dissolution – break up whole corp Entity sale – sell the whole business Merger or combination of the whole firm Try to avoid closing down the corp b/c everyone loses from the end of a going

concern, but major responses tend to follow from major changes…o Share Transfers

General rule – shares are transferable Shares are property – can’t restrict alienability To make them NOT transferable requires specific change Though transfers can be conditioned, regulated – according to state law

Compare w/ partnership transfers – partnership interest isn’t transferable, right to receive dividends might be but new holder won’t become a partner

Most shares in close corps are subject to transfer restrictions Shares may not be sold except in compliance w/ share transfer agreement

Purpose of restrictions See that stock doesn’t go to undesirable owners

o Preventing certain people from getting stocko Preventing stock from going to people in ways that destroys initial

exemptions from fed filing Ex. Initial offering fit private offering exemption or was entirely in state

transfer to certain people will destroy exemption, invalidate entire initial offering

Problem – locks in s’holderso Need exit options too

Typical forms of restraints First option restraint

o S’holders have to first offer shares to someone in the corp on the set terms, and if initial offeree accepts, s’holder must sell to him

o Need to offer the shares to parties within the firm before offering them to parties outside the firm

o Prevents closely held shares from falling into hands of outsiders Policy – reflects fear that if s’holder offers stock to unwelcome 3rd party,

it might create more problems for the corp in the long run Also reflects interest in making share transfer/exit as easy as possible

General transfer review – require that sales/transfers can’t occur without review/approval of corp counsel

Typical triggers Termination, voluntary s’holder exit Death

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Transfers take value at fair market value at time of transfer Most important issue – Valuation

Need to pick a mechanism triggering a buy out, but also need to set way to value interests being bought

For a close corp there’s no public market valuation May want to keep public ownership as the option – let shares go on market to

have them valued and then buy out interests…o Esp good option as value of corp increases

Technical requirements for share transfer agreements/restrictions No bearer share format in the US – ownership of share doesn’t get transferred

until corp registers share transfero Corp is ultimately in control

Restriction on transferability can only be imposed on initial issuance of shares or by consent of shareholderso Can’t take already outstanding shares and then restrict them – shares are a

property right, can’t constitutionally deprive s’holders Restriction must be noted on the face of each share – clear notice

o Printed notice – eliminates possible challenges Restrictions remain operative only w/ respect to buyers who have knowledge and

have consentedo Don’t want to transfer stock to people who don’t know or consent to

restrictions b/c that would undermine the validity of the whole agreement If all requirements are met, courts will typically enforce these agreements, as

long as entered into w/o fraud, duress, etco Courts wont look to underlying consideration…

o Del. §202 – Statutory authority to do something w/ stock of a corp that changes its inherent nature Reflects the contractarian nature of close corp law

Shareholder Deadlock Issues: How does deadlock get handled in a close corp situation? Majority of the board controlso Prevention measures?

Bigger board, bringing in outside voters Nothing to prevent deadlock in 2 person board

Without giving directors unequally weighted vote – but that’s too dangerous, incumbency carries too much power

6. McQuade v. Stoneham (N.Y.1934) – Shareholder control (not just voting) agreement Action brought to compel specific performance of a voting agreement. Part of the agreement

also concerned internal operations - that as directors, parties would vote for each other as officers and agree to a set salary

Are shareholder voting agreements binding, enforceable? YES, but not this one, gave away too mucho To what extent and under what terms can an agreement among s’holders alter the internal

structure of the corp? What does this do to the management of business affairs of the corp under the board (the default)?

o Under common and statutory law - NY BCL § 620(a) or Del. GCL § 218o But this one wasn’t - directors were bound to vote together in a certain manner, which

conflicts with their fiduciary duty, and is thus void against public policy. The voting agreement set salaries of officers and who should be the officers – court held that “the

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business of a corporation shall be managed by the board of directors,” not the shareholders

o Court holds that a contract is illegal so far as it precludes the board of directors from changing officers, setting salaries or policies, except by consent of contracting parties Board’s single most important function is the choice of officers – can the

shareholders impinge on that?o Absent some constriction on their powers from the shareholders, the board has the power

to determine the officers of a corporation Even if the board violates a contract, it retains these powers

General Rule: S’holders have a right to elect the board, but absent a special provision, they don’t have the right to name officers, remove officers, declare dividends, determine operating structure of the corp (still true)o Here, can’t sterilize the board on some issues… overturned.o Note that this is expressly overturned by NYBCL §620(b).

Siegel : The board is bound by a fiduciary duty to all shareholders, even minority ones who didn’t get to elect anyone to the board. If the board chooses themselves as officers and they screw up company, then they will be liableo But fiduciary obligations reside in the directors, not the owners – owners can/should

speculate with their ownership interest Corporate shareholder is NOT a fiduciary for other s’holders. Just fiduciaries of the

corp. If you limit directors’ ability to carry out their obligations by requiring a slate of

officers, fiduciary obligations are being compromised, director may not acutally be able to carry out obigations

o Basic point makes sense when dealing with minority shareholders, but in this case it was unanimous. What fiduciary duty can be violated if 100% agree?

o Advantages of voting agreement: more flexibility, guaranteed anonymity, longer term. Disadvantages: not self-enforcing (have to haul other shareholders into court if they decide not to go along with it). If starting with a clean slate, best to do it by cumulative voting

7. Clark v. Dodge (N.Y. 1936) - Validating an agreement that goes deeper than voting Shareholder agreement provided that plaintiff would be elected director, made general

manager as long as he was “faithful, efficient, and competent,” paid 1/4th of the net income of the corporation, and that no other officer would be paid an unreasonable salary.

Was the agreement enforceable? YES. Same court affirms a similar agreement that says that Clark should share secret formula with son of Dodge, but that Dodge has to use his stock control to continue Clark as director and general manager. Now, this is taken care of by NY § 620(b).o Logical test for whether agreement is valid has to do with whether it is unfair to minority

shareholders.o Confines McQuade opinion to the facts of the case.

8. Galler v. Galler (Ill. 1964) Family business, providing for dividend benefits to surviving spouse if earned surplus >

$500ko Foundation in explicit terms for the contractarian approach to corporate organization.

Terms of the agreement designed through close consultation of the shareholders. Was shareholder agreement valid? YES. Close-held corporations have more leeway in this

sense. (Pathbreaking common law case for agreements in close corps)

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o First case to say that in a unanimous agreement, you can change the board structure. A truly intrusive agreement: voting, replacement of directors, salary continuation arrangements, retirement arrangements. Even if not a voting agreement, shareholders can construct their own corporate

form… Test for whether a shareholder agreement is valid:

o No complaining minority shareholderso No apparent injury to public or creditorso No language clearly prohibited by statute

General Rule: When all shareholders sign an agreement, even if it delves into the details of the corporation’s structure, because it’s justified by the interests of the parties and because there are no minorities to be injured by it, it is 1) valid; 2) specifically enforceable.o Unless there is a policy problem, the affirmative decisions of the shareholders should

control Consequences – changes to state corp laws to codify this concept

o Question – do such statutes fully occupy the field? Probably – look at formalism and underlying equities Planning – better to tie agreements directly to statutes

9. Ramos v. Estrada (Cal.App.4 th 1992) Question here is the distinction between a shareholders’ agreement and a proxy (which can

expire, must be changed according to the will of the shareholder, and is otherwise subject to more rules).

General Issue – in a state where there’s actual law qualifying close corps, what happens to agreements entered into on shareholder level if corp hasn’t officially filed as close corp?o Shareholders enter into agreement w/ intent to have it enforced, but corp isn’t officially

close corp under state lawo Is corp still eligible for benefits of close corp status? Does bring flexibility…

Is agreement valid even though s’holders haven’t filed for closed corp status? YES.o Under California law, corporation does not have to be legally a “closed corporation” for

any number of shareholders to enter into voting agreement.o Consider the equities, spirit of the law - even if you don’t fall into exact categories of the

statute, agreement will still probably be valid as long as it is unanimous. Under common law, if nobody’s harmed and it’s unanimous, ct will probably still enforce it.

Siegel : as a practitioner, don’t be comfortable with this holding – don’t want client’s agreement to have to be tested in court. You should tell client to comply with statutory provisions so that agreement isn’t attackable in some wayo This agreement also looked a lot like a voting agreement – didn’t require such a stretch

by the courts Lesson: If parties agree, and agreement doesn’t violate public policy, courts will enforce it.

Once you write an agreement, wise or unwise, there is a strong likelihood that the court will enforce it against parties

Planning Pointers: 1) Dispute Avoidance (Ex: upon death, have share transfer restrictions so that shares have to be offered first to remaining shareholders before offered to anyone else); 2) Dispute Resolution (mediation, mandatory buyout, expulsion, contractual dissolution, all are superior to what ct would do); 3) Exit strategy

10. Zion v. Kurtz (NY Ct. of Appeals) Deciding on a shareholder agreement under Del. Law

o But there was no Del. Law to apply on this point Was a unanimous agreement, concerning internal details of corp operation

o Clearly a shareholder agreement, not done under either NY or Del. Provisions

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Valid agreement? YES.o Putting agreement into articles of inc helps for publicity value, but courts wont look

kindly on shareholders who know what they got into, had notice of the agreement and try to escape after the fact on basis that agreement wasn’t in articles…

o Courts are going to look at the underlying equities – contractarian structure but equitable considerations…

11. Planning the Close Corporation Structure What do these cases, statutes really mean? What does it mean to be a close corporation? What

are we going to do within this statutory framework? Effects of a highly permissive structure (like partnership as well) that validates and enforces

any kind of agreement that the parties enter into (subject to public policy limits) puts a premium on good lawyeringo NEED to structure the agreements well, properly, in detailo Lawyers arent as concerned that the agreements will be enforced, but how they’ll be

enforced Important questions for the structuring of the corporation:

o Develop ideas about a management structure, dispute resolution structure, compensation structure… that are going to be workable in the long run

o Management Move from the most general to more specific – election of the board choice of

officers control over specified areas (one officer controls all financial matters, no decisions involving more than X$ can be made without her consent – VERY specific)

Need to also consider terms, qualifications, substitution, removal for all officers/directors

Employment in general o Finance – questions of salaries, dividends, retirement, expenditures, borrowing

All elements of financial controlo Exit and Share transferso There is no standard answer to any of these questions – that’s the point

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